[Senate Prints 108-18]
[From the U.S. Government Publishing Office]
108th Congress S. Prt.
COMMITTEE PRINT
1st Session 108-18
_______________________________________________________________________
U.S. STRATEGIC PETROLEUM RESERVE:
RECENT POLICY HAS INCREASED COSTS
TO CONSUMERS BUT NOT OVERALL
U.S. ENERGY SECURITY
__________
R E P O R T
prepared by the
MINORITY STAFF
of the
PERMANENT SUBCOMMITTEE ON
INVESTIGATIONS
of the
COMMITTEE ON GOVERNMENTAL AFFAIRS UNITED STATES SENATE
[GRAPHIC] [TIFF OMITTED] TONGRESS.#13
March 5, 2003
85-551 U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 2003
____________________________________________________________________________
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COMMITTEE ON GOVERNMENTAL AFFAIRS
SUSAN M. COLLINS, Maine, Chairman
TED STEVENS, Alaska JOSEPH I. LIEBERMAN, Connecticut
GEORGE V. VOINOVICH, Ohio CARL LEVIN, Michigan
NORM COLEMAN, Minnesota DANIEL K. AKAKA, Hawaii
ARLEN SPECTER, Pennsylvania RICHARD J. DURBIN, Illinois
ROBERT F. BENNETT, Utah THOMAS R. CARPER, Delaware
PETER G. FITZGERALD, Illinois MARK DAYTON, Minnesota
JOHN E. SUNUNU, New Hampshire FRANK LAUTENBERG, New Jersey
RICHARD C. SHELBY, Alabama MARK PRYOR, Arkansas
Michael D. Bopp, Staff Director and Chief Counsel
Joyce Rechtschaffen, Minority Staff Director and Counsel
Darla D. Cassell, Chief Clerk
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PERMANENT COMMITTEE ON INVESTIGATIONS
NORM COLEMAN, Minnesota, Chairman
TED STEVENS, Alaska CARL LEVIN, Michigan
GEORGE V. VOINOVICH, Ohio DANIEL K. AKAKA, Hawaii
ARLEN SPECTER, Pennsylvania RICHARD J. DURBIN, Illinois
ROBERT F. BENNETT, Utah THOMAS R. CARPER, Delaware
PETER G. FITZGERALD, Illinois MARK DAYTON, Minnesota
JOHN E. SUNUNU, New Hampshire FRANK LAUTENBERG, New Jersey
RICHARD C. SHELBY, Alabama MARK PRYOR, Arkansas
Elise J. Bean, Minority Staff Director and Chief Counsel
Dan M. Berkovitz, Minority Counsel
Laura Stuber, Minority Counsel
Mary D. Robertson, Chief Clerk
C O N T E N T S
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Page
I. EXECUTIVE SUMMARY............................................. 1
A. Findings................................................. 1
B. Recommendations.......................................... 4
C. Overview................................................. 5
II. THE U.S. STRATEGIC PETROLEUM RESERVE......................... 11
A. Introduction............................................. 11
B. Withdrawals From the SPR................................. 12
1. Emergency Drawdown.................................... 12
2. Exchanges............................................. 12
3. Non-Emergency Sales................................... 13
4. The 2000 Swap: Release of 30 Million Barrels.......... 13
C. Filling the SPR.......................................... 15
1. Initial Fill of the SPR............................... 15
2. Recent and Current Programs to Fill the SPR........... 16
a. 2000 Swap Refill................................... 16
b. 1999 Royalty-In-Kind (RIK) Program................. 17
c. 2001 RIK Program to Fill the SPR to 700 Million
Barrels.................................................... 18
3. Strategy for Filling the SPR.......................... 21
a. Different Types of Crude Oil May Be Placed in the
SPR........................................................ 21
b. Market-Based Acquisition Strategy and Fill
Schedules.................................................. 22
c. SPR Market-Based Procedures Abandoned.............. 24
III. THE PRICING OF CRUDE OIL.................................... 25
A. Overview of Crude Oil Markets............................ 27
1. Term Contracts........................................ 28
2. Crude Oil Spot or Cash Market......................... 29
3. Crude Oil Futures Markets............................. 30
4. Over-the-Counter Markets.............................. 39
5. Convergence of Futures and OTC Markets................ 44
6. Disparity in Market Disclosure and Oversight.......... 45
B. Crude Oil Price Benchmarks............................... 48
1. Brent Crude Oil....................................... 48
a. 15- and 21-Day Brent............................... 51
b. Brent Spot Market: ``Dated Brent''................. 53
c. Brent Futures Markets.............................. 53
d. Brent Over-the-Counter Markets..................... 54
2. West Texas Intermediate (WTI)......................... 56
3. Dubai................................................. 57
C. The Vulnerability of the Brent Market to Squeezes........ 58
IV. CASE STUDY: THE COSTS OF FILLING THE SPR IN SPRING 2002..... 69
A. Introduction............................................. 69
B. Analysis................................................. 70
1. Large Amounts of Brent Crude Oil Were Put Into the
SPR in Late 2001 and Early 2002............................ 70
2. The Use of Brent to Fill the SPR Increased the Price
of Brent Relative to WTI................................... 73
3. Higher Brent Prices Increased the Price of Crude Oil
Imported into the United States............................ 77
4. Higher Costs for Imported Crude Oils Led to Fewer
Imports.................................................... 79
5. High-Priced Imports Led Refiners to Use Crude Oil in
Existing Inventories....................................... 87
6. Decreasing U.S. Inventories Spiked the Price of WTI... 88
7. WTI Price Spike Led to Price Spikes for Home Heating
Oil, Jet Fuel, and Diesel Fuel............................. 95
8. Higher Home Heating Oil, Jet Fuel, and Diesel Fuel
Prices Hurt U.S. Consumers and Businesses.................. 97
9. High Crude Oil Prices Increased Refiners Costs........ 100
C. Oil Company Decisions to Send So Much Brent to the SPR... 103
V. THE 2002 SPR FILL PROGRAM..................................... 107
A. DOE Changed SPR Policy to Require SPR Fills Regardless
of Oil Prices.............................................. 107
B. SPR Career Officials Opposed Policy Change and Warned
DOE the New Policy Would Increase Oil Prices, Consumer and
Taxpayer Costs............................................. 111
C. SPR Career Officials Warned DOE the New Policy Would
Reduce U.S. Crude Oil Commercial Inventories............... 114
D. SPR Document States Filling the SPR Without Regard to
Oil Prices Was Not Justified Even If A Major Supply
Disruption Were Imminent................................... 121
E. 2002 SPR Fills Increased Consumer Costs But Not U.S. Oil
Supplies................................................... 122
APPENDIX 1: PREVENTING MANIPULATION IN COMMODITY MARKETS......... 125
I. OVERVIEW...................................................... 125
II. THE LAW OF MANIPULATION...................................... 126
A. Anti-Manipulation Prohibition in Commodity Exchange Act.. 126
1. Market Power.......................................... 129
2. Specific Intent to Create an Artificial Price......... 132
3. Artificial Price...................................... 135
4. Causation............................................. 136
5. Summary............................................... 137
B. Market Oversight to Detect and Prevent Manipulation...... 138
1. CFTC Market Oversight................................. 138
2. Market Oversight by Approved Futures Exchanges........ 141
C. Lessons Learned from the Sumitomo Manipulation of the
Copper Markets............................................. 143
1. Sumitomo Manipulation of the Copper Markets........... 143
2. International Agreement to Address Problems Raised by
Sumitomo................................................... 148
APPENDIX 2: HISTORY AND CURRENT STATUS OF COMMODITY MARKET
REGULATION..................................................... 153
I. LEGISLATIVE HISTORY OF THE COMMODITY EXCHANGE ACT............. 153
A. Background on Commodities Exchanges and Need for
Regulation................................................. 153
B. The Commodity Exchange Act............................... 155
1. Grain Futures Act of 1922............................. 155
2. Commodity Exchange Act................................ 157
3. 1968 Amendments....................................... 158
4. 1974 Amendments: Creation of CFTC..................... 159
II. GOVER-THE-COUNTER ENERGY DERIVATIVES: EXCLUSIONS AND
EXEMPTIONS FROM COMMODITY EXCHANGE ACT......................... 163
A. 1989 Swaps Policy Statement: Exemption for Certain OTC
Swap Transactions.......................................... 163
B. Exemptions for Certain Brent Crude Oil Contracts......... 164
1. The Transnor Decision................................. 164
2. Industry Response to Transnor......................... 167
3. CFTC: 15-Day Brent Contracts are Forward Contracts.... 168
C. Exemptions for Energy Contracts.......................... 173
1. Futures Trading Practices Acts of 1992................ 173
2. CFTC Exemption for Energy Contracts................... 176
a. CFTC Order Granting Exemption...................... 176
b. Congressional Hearings on CFTC Order............... 179
D. The Commodity Futures Modernization Act of 2000.......... 183
1. Regulatory Uncertainty Following the FTPA............. 183
2. Enactment of Commodity Futures Modernization Act...... 185
a. Summary of Relevant Provisions..................... 185
b. Outstanding Issues................................. 192
APPENDIX 3: EXHIBITS............................................. 194
EXHIBIT II-1................................................. 194
EXHIBIT II-2................................................. 204
EXHIBIT III-1................................................ 217
EXHIBIT V-1.................................................. 219
EXHIBIT V-2.................................................. 220
EXHIBIT V-3.................................................. 221
EXHIBIT V-4.................................................. 222
EXHIBIT V-5.................................................. 227
EXHIBIT V-6.................................................. 228
EXHIBIT V-7.................................................. 229
EXHIBIT V-8.................................................. 233
EXHIBIT V-9.................................................. 234
EXHIBIT V-10................................................. 240
EXHIBIT V-11................................................. 243
EXHIBIT V-12................................................. 244
APPENDIX 4: ADDITIONAL DOCUMENTS................................. 247
1. Transcript of Interview of Dr. Philip Verleger on
National Public Radio on March 7, 2003, regarding impact of
no-deferral policy in 2002 on the price of crude oil,
gasoline, and heating oil.................................. 247
2. Analysis by Dr. Philip Verleger, ``Measuring the Economic
Impact of an Oil Release from the Strategic Petroleum
Reserve to Compensate for the Loss of Venezuelan Oil
Production,'' March 20, 2003............................... 249
3. Department of Energy Statement in Response to Minority
Staff Report, March 5, 2003................................ 260
4. Excerpt from Subcommittee Minority Staff presentation on
the Minority Staff Report, regarding the significance of
the 2002 fill rate of 135,000 barrels/day on the level of
U.S. commercial crude oil inventories, March 14, 2003...... 261
5. Additional DOE document on SPR fill policy, dated June
11, 2002, prepared by DOE SPR Office and Subcommittee on
March 19, 2003............................................. 266
6. Correspondence between Senators Levin and Collins and
Senator Levin and U.S. Department of Energy regarding
production of documents related to SPR fill rates and
policy..................................................... 279
U.S. STRATEGIC PETROLEUM RESERVE:
RECENT POLICY HAS INCREASED
COSTS TO CONSUMERS BUT NOT OVERALL
U.S. ENERGY SECURITY
----------
I. EXECUTIVE SUMMARY
In June 2001, the U.S. Senate Permanent Subcommittee on
Investigations, then under the Chairmanship of Senator Carl
Levin (now Ranking Minority Member), initiated an investigation
into the increased volatility of U.S. retail gasoline prices in
recent years. In April 2002, the Subcommittee released a staff
report,\1\ Gas Prices: How Are They Really Set?, and held
hearings on retail gasoline pricing and the operation of the
gasoline refining and marketing industry. During the course of
this investigation, in early 2002, the Subcommittee learned of
allegations that the U.S. Department of Energy's program to
fill the U.S. Strategic Petroleum Reserve (SPR) was causing
crude oil prices to rise significantly. The Subcommittee also
learned of allegations that certain companies were manipulating
crude oil prices on the New York and London futures exchanges.
The Subcommittee initiated an investigation into these crude
oil pricing issues that affect not only retail gasoline prices,
but also prices for other key petroleum products, such as home
heating oil, jet fuel, and diesel fuel.
---------------------------------------------------------------------------
\1\ Report printed in PSI hearings held Apr. 30 and May 2, 2002, S.
Hrg. 107-509, Gas Prices: How Are They Really Set?'' on page 322.
---------------------------------------------------------------------------
As part of its investigation, Subcommittee Minority staff
met with the U.S. Department of Energy (DOE), including its SPR
Office, the U.S. Commodity Futures Trading Commission (CFTC),
and the United Kingdom Financial Services Authority;
interviewed representatives from futures exchanges in Chicago,
New York, and London, and the Intercontinental Exchange (ICE)
based in Atlanta; interviewed crude oil traders and officials
from a number of companies that purchase, sell, and trade crude
oil; and spoke with oil industry economists, representatives
from crude oil price reporting services, and other oil industry
experts. The Subcommittee Minority staff also reviewed
extensive price and trading data from the New York and London
crude oil futures markets; case law and legal analyses related
to commodity market regulation and manipulation; numerous
academic, economic and industry publications related to crude
oil; and documents provided by DOE in response to Subcommittee
requests. The Subcommittee Minority staff then prepared this
Report describing the findings of the investigation and
offering recommendations for corrective action.
A. Findings
Based upon the evidence obtained during its investigation
into how recent measures to fill the SPR have affected crude
oil markets, the U.S. Senate Permanent Subcommittee on
Investigations Minority staff makes the following findings. The
findings are organized according to the two major areas of
inquiry of this investigation: (1) the filling of the SPR; and
(2) the operation of the crude oil markets.
U.S. Strategic Petroleum Reserve
1. IN 2002, DOE BEGAN TO FILL THE SPR WITHOUT REGARD TO
THE PRICE OF OIL. The SPR Program was established to ``store
petroleum to reduce the adverse economic impact of a major
petroleum supply interruption.'' Following the tragic events of
September 11, 2001, in November 2001, President Bush directed
the Department of Energy to fill the SPR to its capacity of 700
million barrels ``in a deliberate and cost effective manner.''
In early 2002, DOE decided to fill the SPR without regard to
crude oil prices. Reversing a longstanding policy of filling
the SPR when crude oil prices were relatively low and deferring
oil deliveries when prices were relatively high, DOE stopped
granting requests to defer SPR oil deliveries. In 2002, DOE
deposited about 40 million barrels of oil in the SPR at prices
ranging from under $20 to over $30 per barrel.
2. FILLING THE SPR IN A TIGHT MARKET INCREASED U.S. OIL
PRICES AND HURT U.S. CONSUMERS. DOE ignored warnings by career
staff that filling the SPR when oil prices were high and oil
supplies were tight could drive oil prices higher and hurt
consumers, did not conduct a cost-benefit analysis of the new
policy, and did not attempt to estimate or track consumer or
taxpayer costs. A Subcommittee Minority staff case study
illustrates the high costs of the new SPR fill policy. In late
2001 and early 2002, about 25 million barrels of Brent crude
oil were deposited into the SPR despite already tight supplies
on world markets. In a 1-month period in mid-2002, crude oil
price increases caused by SPR deposits spiked the U.S. spot
price of home heating oil by 13 percent, jet fuel by 10
percent, and diesel fuel by 8 percent, imposing on U.S.
consumers additional crude oil costs of between $500 million
and $1 billion. Since then, high crude oil prices have boosted
the cost of gasoline, heating oil, jet fuel, and diesel fuel,
generating the types of adverse economic impacts on U.S.
consumers the SPR program was designed to prevent.
3. FILLING THE SPR REGARDLESS OF OIL PRICES INCREASED
TAXPAYER COSTS. Prior to 2002, DOE routinely granted oil
company requests to defer scheduled oil deliveries to the SPR
when near-term oil prices were high compared to longer-term
prices (i.e. during market backwardation), in return for
deposits of extra oil at a later date. In 2000 and 2001, DOE
used these deferrals to save taxpayers over $175 million and
add 7 million barrels to the SPR. By denying deferral requests
for most of 2002, DOE missed opportunities for comparable
taxpayer savings and extra SPR oil. Also, by using federally-
owned oil acquired from offshore oil leases for the SPR instead
of selling the oil on the market when prices were high, DOE
reduced revenues supporting taxpayer-funded programs. For
example, at the 2002 SPR fill rate of 100,000 barrels per day,
filling the SPR when crude oil is priced at $30 per barrel
rather than $20 per barrel costs taxpayers an additional $1
million per day. Over 3 months, the additional cost of filling
the SPR approaches $100 million, a cost ultimately borne by
U.S. taxpayers.
4. DESPITE ITS HIGH COST, FILLING THE SPR DID NOT INCREASE
OVERALL U.S. OIL SUPPLIES. In 2002, DOE put about 40 million
barrels of crude oil into the SPR, increasing the total 7
percent, from about 560 million to 600 million barrels.
Removing 40 million barrels from the marketplace, however,
increased oil prices, which caused U.S. oil refiners to take
oil from inventory instead of buying expensive new oil. In
2002, U.S. commercial crude oil inventories dropped 10 percent,
from about 310 to 280 million barrels. In 2003, commercial
inventories dropped again to less than 270 million barrels.
Today, overall oil supplies in the United States, which
consists of oil in the SPR and commercial inventories, total
about 870 million barrels, about the same amount as at the end
of 2001, before the recent SPR fills. Although the SPR program
has placed more oil under government control, lower private
sector oil inventories mean there has been no net increase in
overall national oil supplies.
5. 2003 SPR DELIVERIES WILL DRIVE OIL PRICES HIGHER.
Today, crude oil prices are at a 12-year high, and U.S.
commercial crude oil inventories are at record lows,
threatening refinery disruptions due to inadequate oil
supplies. In these market conditions, unless more oil enters
the marketplace, new SPR contracts to remove another 40 million
barrels from the U.S. market in 2003, if carried out, will
further shrink commercial supplies, drive oil prices higher,
and impose more costs on U.S. consumers and taxpayers.
U.S. Crude Oil Markets
6. U.S. CRUDE OIL FUTURES MARKET NEEDS TO BE IMPROVED. In
2002, after SPR deliveries removed oil from the marketplace,
defects in the New York and London crude oil markets magnified
local supply and demand imbalances into large increases in the
price of crude oil. Although the London market made major
improvements to correct defects in the Brent market, the New
York Mercantile Exchange (NYMEX) has not made needed
improvements to the West Texas Intermediate (WTI) futures
contract that plays a key role in U.S. crude oil markets.
7. THE UNAVAILABILITY OF KEY INFORMATION ON OVER-THE-
COUNTER TRADING ACTIVITY MAKES DETECTION AND PREVENTION OF
PRICE MANIPULATION DIFFICULT, IF NOT IMPOSSIBLE. Crude oil
prices are affected by trading not only on regulated exchanges
like the NYMEX, but also on unregulated ``over-the-counter''
(OTC) markets that have become major trading centers for energy
contracts and derivatives. The lack of information on prices
and large positions in OTC markets makes it difficult in many
instances, if not impossible in practice, to determine whether
traders have manipulated crude oil prices.
B. Recommendations
Based upon the evidence obtained during its investigation
and the findings in this Report, the U.S. Senate Permanent
Subcommittee on Investigations Minority staff makes the
following recommendations.
U.S. Strategic Petroleum Reserve
1. DEFER 2003 SPR DELIVERIES. DOE should defer all SPR
deliveries scheduled for 2003, until near-term crude oil prices
fall and U.S. commercial inventories increase. DOE should
publicly announce this policy change to calm markets by making
it clear the SPR will not further reduce commercial oil
supplies under current market conditions.
2. CONDUCT COST-BENEFIT ANALYSIS. DOE should analyze the
costs and benefits of the current policy to fill the SPR
without regard to oil prices and without deferrals, compared to
its prior policy of filling the SPR when oil prices are
relatively low and deferring deliveries when oil prices are
relatively high or supplies are tight and the contractor agrees
to deliver extra oil at a later time. When measuring the
benefits, DOE should analyze whether U.S. energy security is
better measured by considering only the amount of oil under
government control or also the amount of oil in U.S. commercial
inventories.
3. RESTORE MARKET-BASED CRITERIA FOR GRANTING DEFERRALS.
DOE should restore its SPR business procedures allowing
deferrals of oil deliveries to the SPR when crude oil prices
are high or commercial crude oil supplies are tight, and the
contractor agrees to deliver extra oil to the SPR at a later
time. DOE should ensure these procedures allow timing SPR
deliveries to avoid increased U.S. oil prices, reduced U.S.
commercial oil inventories, and added U.S. consumer and
taxpayer costs.
U.S. Crude Oil Markets
4. REVISE NYMEX WTI FUTURES CONTRACT. The Commodity
Futures Trading Commission (CFTC) and NYMEX should work
together to revise the NYMEX WTI futures contract to reduce
price volatility caused by local supply and demand imbalances
in the U.S. WTI market. One option to strengthen price
stability is to allow crude oil deliveries under the WTI
contract to take place at more locations than the one location
now specified at Cushing, Oklahoma.
5. INCREASE OTC DISCLOSURE. Congress should authorize the
CFTC, which oversees commodity markets, to require traders in
OTC markets to provide the CFTC with routine information on
large positions in crude oil and energy contracts and
derivatives, as well as other information that would aid the
CFTC in detecting, preventing, and halting commodity market
manipulation.
6. STRENGTHEN INTERNATIONAL COOPERATION. The CFTC should
strengthen efforts with its counterparts in other countries to
implement the Tokyo Communique, including advancing mechanisms
to increase reporting of over-the-counter trading positions and
coordinating international efforts to detect, prevent, and halt
commodity market manipulation.
C. Overview
U.S. Strategic Petroleum Reserve
The United States, which consumes nearly 25 percent of the
70-80 million barrels of crude oil produced daily worldwide, is
by far the largest purchaser and importer of crude oil in the
world today. The United States consumes about 18 million
barrels each day and imports about 10 million barrels each day
to meet approximately 60 percent of its daily needs. Most of
this oil, about 90 percent, is refined into fuel products such
as gasoline, home heating oil, jet fuel, and diesel fuel. The
crude oil market is the largest commodity market in the world,
and hundreds of millions of barrels are traded daily in the
crude oil spot, futures, and over-the-counter markets. The
world's leading exchanges for crude oil futures contracts are
the New York Mercantile Exchange (NYMEX) and the International
Petroleum Exchange (IPE) in London.
In 2002, the price of crude oil in the United States nearly
doubled, climbing from a low of around $18 per barrel in
January to a high of $34 per barrel in December. Crude oil
prices have continued to climb and recently reached a 12-year
high of nearly $40 per barrel.
Several global political events and economic forces were
major factors pushing prices upward over this period: The
steady erosion of large crude oil supplies that had built up
immediately after the terrorist attacks on September 11, 2001;
Saddam Hussein's 1-month suspension of Iraqi oil exports in
April 2002; labor strikes in Venezuela in late 2002 that
virtually shut down crude oil production and exports to the
United States; U.S. industry's practice of keeping relatively
limited crude oil inventories; and increasing speculation and
concern over impending war with Iraq.
In addition to these political and economic factors
affecting global crude oil supply and demand, a large player
entered the crude oil market in late 2001, and significantly
affected global crude oil trading throughout 2002--the U.S.
Department of Energy's (DOE) Strategic Petroleum Reserve (SPR)
program.
The purpose of the SPR is to ``store petroleum to reduce
the adverse economic impact of a major petroleum supply
interruption to the United States.'' Established in 1975, after
the oil shortages of the early 1970's, the SPR has enjoyed
strong and ongoing support in Congress and subsequent
Administrations as a means to strengthen U.S. energy security
and protect the U.S. economy from the negative economic
consequences of a major oil shortage.
In November 2001, following the tragic events of September
11th, President Bush directed the Department of Energy to fill
the SPR to its full capacity of 700 million barrels ``in a
deliberate and cost effective manner.'' Very little oil had
been added to the SPR since 1995, when the amount of oil in the
Reserve totaled about 590 million barrels. Due to several
withdrawals since then, by 2001 the total amount of oil stored
in the SPR had declined to about 540 million barrels.
In late 2001, when the new policy to fill the SPR to
capacity was announced, crude oil prices were low and market
supplies were plentiful--favorable market conditions for
filling the SPR. As crude oil markets tightened in 2002,
however, DOE's determination to direct millions of barrels out
of the commercial marketplace and into the Federal Government's
SPR regardless of market conditions became a major factor
pushing prices upward and commercial oil inventories downward.
The SPR Office had formerly used a market-based approach to
filling the SPR, acquiring more oil when prices were relatively
low and less oil when prices were relatively high. This
approach took into account market conditions and allowed DOE to
fill the SPR without significantly affecting crude oil market
supplies or prices. Pursuant to this policy, using procedures
most recently published in January 2002, DOE had routinely
allowed oil companies to defer scheduled oil deliveries to the
SPR when market prices were relatively high in return for
providing additional barrels of crude oil at a later time. In
February 2002, 1 month after the deferral procedures were
published, however, DOE informed the SPR Office that requests
to defer SPR deliveries would no longer be granted. Under this
new no-deferral policy, which DOE publicly announced in April
2002, oil was to be deposited into the SPR regardless of the
price of oil on the markets.
DOE documents show SPR career officials did not support
discarding the market-based strategy they had been using to
fill the SPR. SPR career officials accurately warned about the
negative consequences of filling the SPR when oil prices were
high and oil supplies were tight, predicting it could lead to
``explosive price swings,'' higher trade deficits, and higher
costs for taxpayers. SPR career officials also accurately
warned that higher prices would cause U.S. refiners to take oil
from inventory instead of buying expensive new oil, resulting
in lower total U.S. commercial inventories of crude oil.
Reducing U.S. commercial crude oil inventories undercuts the
fundamental purpose of the SPR program--to ensure this nation
has adequate supplies of crude oil in the event of a supply
disruption.
One senior SPR career official wrote that the new SPR fill
policy ``appears irrational to the market place'' and ``was
discredited years ago.'' He also warned: ``Insisting on [SPR]
deliveries in a tight market would be heavily criticized as
mismanagement and would be difficult to defend.''
DOE ignored these warnings and initiated the new SPR fill
policy in February 2002, without conducting a cost-benefit
analysis or attempting to estimate or track consumer or
taxpayer costs. Section IV of this Report provides a detailed
case study illustrating the high costs of this new SPR fill
policy, which was compounded by the type of crude oil deposited
into the SPR. From November 2001 through May 2002, about 25
million barrels of Brent crude oil were deposited into the SPR
despite tightening Brent supplies on world markets. Brent crude
oil provides a ``benchmark'' price for the price of two-thirds
of the crude oil traded globally, and most of the Brent crude
oil produced from March to May was sent to the SPR.
The placement of so much Brent crude oil into the SPR
created a shortage of Brent on world markets. This shortage
drove up the price of not only Brent, but also other crude oils
linked to the price of Brent. These price increases pushed up
the cost of crude oil exports to the United States from Europe
and Africa.
Due to the increased price, resulting from both tighter
market supplies in general and Brent in particular, U.S.
refiners bought fewer barrels of expensive imported crude oil,
choosing instead to draw down their inventories for refining
crude oil into gasoline. As U.S. inventories declined, oil
companies and traders began bidding up oil prices on the major
U.S. crude oil exchange, the NYMEX, in the belief that there
was a crude oil shortage in the United States. This trading led
to a spike in the price of the principal crude oil traded on
the NYMEX, West Texas Intermediate (WTI).
The sudden, sharp increase in the WTI price, which rose 20
percent, or $5 per barrel, from mid-April to mid-May 2002,
resulted in the spiking of prices of U.S. fuel products,
including the spot price of home heating oil, which jumped 13
percent; jet fuel, which jumped 10 percent; and diesel fuel,
which jumped 8 percent. In the span of 1 month, U.S. consumers
and businesses paid additional costs of $500 million to $1
billion. Since then, high crude oil prices have continued to
boost the cost of gasoline, heating oil, jet fuel and diesel
fuel, generating the types of adverse economic impacts on U.S.
consumers the SPR program was designed to prevent. These added
costs can be viewed, in part, as an ``SPR premium'' imposed on
American consumers by the new SPR fill policy directing crude
oil into the SPR regardless of the price of oil.
Filling the SPR regardless of oil prices has not only
increased U.S. consumer costs, it has also increased U.S.
taxpayer costs. Prior to 2002, DOE routinely granted oil
company requests to defer scheduled oil deliveries to the SPR
when near-term oil prices are high, in return for deposits of
extra oil at a later date. In 2000 and 2001, DOE used these
deferrals to save taxpayers over $175 million and add 7 million
barrels to the SPR. By denying deferral requests for most of
2002, DOE missed opportunities for comparable taxpayer savings
and extra SPR oil. Also, by using federally-owned oil acquired
from offshore oil leases for the SPR instead of selling the oil
on the market when prices were high, DOE reduced revenues
supporting taxpayer-funded programs. For example, at the 2002
SPR fill rate of 100,000 barrels per day, filling the SPR when
the crude oil is priced at $30 per barrel rather than $20 per
barrel costs taxpayers an additional $1 million per day. Over 3
months, the additional cost of filling the SPR approaches $100
million, a cost ultimately borne by U.S. taxpayers.
Despite its high cost to U.S. consumers and taxpayers, the
new SPR fill policy did not increase overall U.S. oil supplies.
In 2002, the SPR program put about 40 million barrels of crude
oil into the SPR, increasing the total 7 percent, from about
560 million to 600 million barrels. Removing 40 million barrels
from the marketplace, however, increased oil prices, which
caused U.S. oil refiners to take oil from inventory instead of
buying expensive new oil. In 2002, U.S. commercial inventories
dropped 10 percent, from about 310 to 280 million barrels. In
2003, commercial inventories dropped again to less than 270
million barrels, which is the lowest level in the United States
in 28 years and below the recognized level at which refinery
operations risk disruptions due to inadequate oil supplies.
Today, overall oil supplies in the United States, which consist
of the oil in the SPR and commercial inventories, total about
870 million barrels, the same amount as at the end of 2001,
before the recent SPR fills. Although the SPR program has
placed more oil under government control, lower private sector
oil inventories mean there has been no net increase in overall
national oil supplies.
The benefit to U.S. energy security of shifting oil from
private sector control to government control in the SPR,
without a net increase in overall oil supplies, is unclear at
best, since in the event of a major supply disruption, the SPR
would act to release oil on the market, shifting supplies back
to the private sector.
Despite spiking U.S. oil prices, shrinking U.S. commercial
inventories, and ongoing efforts by SPR career officials to
restore the program's earlier market-based approach, DOE kept
the SPR no-deferral policy in place throughout most of 2002. In
mid-December, DOE granted three requests to defer approximately
15 million barrels of crude oil scheduled for delivery to the
SPR from December 2002 through March 2003. DOE stated at the
time that the deferrals were granted to avoid ``negatively
affect[ing] the oil market.'' In February 2003, however, with
crude oil at $35 per barrel, DOE announced three new contracts
to deliver another 24 million barrels to the SPR. When added to
prior contracts, this announcement means DOE plans to deposit a
total of 40 million more barrels to the SPR in 2003. DOE also
published an accelerated schedule for these SPR oil deliveries
to attain a rate of about 4 million barrels per month beginning
in April 2003.
Today, crude oil prices are at a 12-year high, and U.S.
commercial inventories are at record lows, threatening refinery
disruptions due to inadequate oil supplies. In these market
conditions, unless more oil enters the marketplace, DOE plans
to remove another 40 million barrels from the U.S. market in
2003, if carried out, will further shrink commercial supplies,
drive oil prices higher, and impose more costs on U.S.
consumers and taxpayers, without any assurance that expanded
overall U.S. oil supplies will result.
Recent SPR fill policy has helped push up U.S. oil prices,
reduce U.S. oil inventories, and hurt U.S. consumers and
taxpayers. In light of the dubious benefits to national energy
security provided by the current SPR fill policy and the high
cost to U.S. consumers and taxpayers, this Report recommends:
(1) a suspension of all 2003 SPR deliveries until near-term
crude oil prices fall and U.S. commercial inventories increase;
(2) an analysis of the relative costs and benefits of the new
market-blind SPR fill policy compared to the prior market-based
policy; and (3) a return to market-based procedures which allow
DOE to time SPR deliveries to avoid increased oil prices,
reduced U.S. commercial oil inventories, and added U.S.
consumer and taxpayer costs.
U.S. Crude Oil Markets
When analyzing the factors influencing crude oil prices in
2002, this investigation also examined the operation of the
crude oil markets and their vulnerability to manipulation. As
described in Section III, crude oil markets today are far
different from the market in the days when the ``Seven
Sisters'' or OPEC ministers met behind closed doors and set
crude oil prices worldwide. Although OPEC still plays a major
role in determining crude oil prices through production quotas,
crude oil prices also respond to the forces of supply and
demand as determined by thousands of buyers and sellers in the
inter-related spot, futures, and over-the-counter (OTC)
commodity markets in which crude oil is traded.
Currently, the U.S. futures markets, such as the NYMEX
market for crude oil, are heavily regulated and are among the
most transparent commodity markets in the world. Commodity
trading on these markets is subject to a variety of reporting
requirements and routine market oversight designed to detect
and deter fraud and manipulation. This regulation and
transparency has bolstered the confidence of traders in the
integrity of these markets and helped propel the United States
into the leading marketplace for many of the commodities traded
on these exchanges.
Increasingly, however, OTC crude oil markets, which are
essentially unregulated, have become major trading centers and
have become intertwined with crude oil trading on the regulated
exchanges. Many of the instruments traded in the OTC markets
and regulated exchanges are virtually identical, traders often
operate in both settings, and both markets handle billions of
dollars in commodity transactions daily, providing traders with
price discovery and opportunities for hedging. Prices on one
market necessarily affect the price of the same and related
commodities on the other markets. Indeed, the NYMEX in New York
and the IPE in London, two leading crude oil futures exchanges,
have integrated their futures trading operations with OTC
electronic trading of crude oil contracts, drawing the two
types of markets closer together. The NYMEX now operates its
own OTC electronic trading facility and even offers a futures
contract for trading on its OTC facility, while the IPE was
recently purchased by ICE, an OTC electronic trading facility
based in Atlanta, Georgia.
The lack of transparency in OTC markets stands in sharp
contrast to the transparency of the regulated exchanges. Many
OTC trades take place either directly between large traders or
through brokers, and there is no reporting of prices or
positions to any market oversight body. While some OTC
electronic trading facilities, such as ICE and the electronic
OTC facility at NYMEX, post bids, offers, and prices
electronically, regulators do not have access to other
information, such as large trader reports, routinely provided
for trading on regulated exchanges. Under current law, OTC
market information is available to the CFTC only upon special
request, rather than on a routine basis for periodic analysis
to detect and deter manipulation. The absence of OTC trading
information means, for example, that suspect trading patterns
cannot be detected in the OTC markets nor can OTC trading
information be compared to information obtained from regulated
exchanges. The absence of OTC information makes it nearly
impossible for regulators and market participants to get a full
understanding of market behavior in order to detect and deter
manipulation.
Because crude oil prices are affected by trading not only
on the regulated exchanges, but also on the unregulated OTC
markets, this Report recommends increasing OTC information
disclosure and market oversight to detect and deter
manipulation. This recommendation is consistent with the
position taken by the United States in 1997, when the CFTC met
with the market regulators from other nations to discuss
strengthening the international regime for preventing commodity
market manipulation. At the end of this meeting all 17
participating countries, including the United States, issued
the Tokyo Communique, which provides guidance and
recommendations to improve commodity market surveillance and
the sharing of information:
[I]nformation should be collected on a routine and non-
routine basis for on-exchange and related cash and
over-the-counter markets and should be designed to
assess whether the market is functioning properly.
Market authorities should have access to information
that permits them to identify concentrations of
positions and the composition of the market.
This Report also finds that, in 2002, after SPR deliveries
removed oil from the marketplace, defects in the New York and
London crude oil futures markets magnified local imbalances
between supply and demand into large price effects. Although
the London market has made major improvements to correct
defects in the Brent market to avoid a recurrence of these
distortions, the NYMEX has not made needed improvements to the
WTI futures contract which plays a key role in U.S. crude oil
markets. To minimize U.S. crude oil price distortions, this
Report recommends that the NYMEX and CFTC work together to
revise the crude oil futures contract traded on the NYMEX to
ensure the contract more accurately reflects national, rather
than local, crude oil supply and demand, including allowing WTI
contract deliveries to take place at more locations than the
one location now specified in the WTI contract at Cushing,
Oklahoma.
The Report's recommendations for short-term improvements in
the SPR fill program and long-term improvements in the crude
oil markets are intended to strengthen U.S. energy security,
curb the economic damage caused by increasing crude oil prices
and tight supplies, and reduce the vulnerability of the U.S.
crude oil markets to manipulation.
II. THE U.S. STRATEGIC PETROLEUM RESERVE
``To maximize long-term protection against oil supply
disruptions, I am directing today the Secretary of
Energy to fill the SPR up to its 700 million barrel
capacity. The SPR will be filled in a deliberate and
cost-effective manner.''
--President George W. Bush, November 13, 2001
A. Introduction
The purpose of the U.S. Strategic Petroleum Reserve (SPR)
is ``to store petroleum to reduce the adverse economic impact
of a major petroleum supply interruption to the United
States.'' \1\ In 1975, following the disruption to the U.S.
economy resulting from the 1973 Arab oil embargo and the
doubling of crude oil prices by the Organization of the
Petroleum Exporting Countries (OPEC), Congress passed and
President Ford signed the Energy Policy and Conservation Act
(EPCA), which, among other energy-conserving measures,
established a national policy to create a one-billion barrel
reserve for the storage of crude oil that could be used in the
event of a disruption in the supply of crude oil. The SPR
program, which is operated by the U.S. Department of Energy
(DOE), through its SPR program office, is designed to help
stabilize domestic crude oil prices by allowing the withdrawal
of oil from the reserve when either supplies are disrupted or
prices are unusually high.
---------------------------------------------------------------------------
\1\ U.S. Department of Energy Strategic Petroleum Reserve,
Strategic Plan, October 2001, page 3.
---------------------------------------------------------------------------
The SPR consists of four large underground caverns hollowed
out from naturally occurring salt domes near the U.S. Gulf
Coast in Texas and Louisiana.\2\ The Gulf Coast sites were
chosen because of their proximity to the extensive port
facilities, pipelines, and refineries in the region, and
because using the natural salt caverns was less expensive than
building new tanks for the storage of the crude oil.\3\
Currently, the SPR holds 600 million barrels and has a physical
capacity of 700 million barrels.\4\ Two basic types of crude
oil streams are deposited and stored in separate caverns in the
SPR: sweet crude oil (with a sulfur content of not greater than
0.5 percent) and sour crude oil (with a sulfur content greater
than 0.5 percent). As of late 2002, approximately two-thirds of
the current inventory is sour crude, and one-third is sweet
crude oil.
---------------------------------------------------------------------------
\2\ For security reasons, the DOE has removed additional
information about these locations from its website.
\3\ Storage costs in the SPR are approximately $1.50 per barrel,
whereas storage in above-ground tanks costs a total of about $15 to $18
per barrel, nearly 10 times the SPR cost. Additionally, the geologic
pressure in the caverns at 2,000-4,000 feet below the surface should
seal any cracks that may appear in the salt, and thereby prevent any
leaks of oil out of the caverns. The temperature differential between
the top and the bottom of the caverns keeps the crude oil circulating
within the cavern, thereby maintaining a consistent quality of oil in
each individual cavern. See DOE SPR website, at SPR-Quick Facts, at
http://www.fe.doe.gov/spr/spr--facts.shtml.
\4\ Id. Congress has authorized the SPR to hold a capacity of one
billion barrels. If the SPR were to be filled to its one-billion barrel
capacity, more physical storage capacity would have to be built or
acquired.
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Crude oil has been withdrawn from the reserve on several
occasions. Currently, the SPR is being filled in two ways: (1)
adding oil through the Royalty-in-Kind (RIK) program; and (2)
replacing oil that was previously swapped out in 2000.
B. Withdrawals From The SPR
DOE is authorized to withdraw crude oil from the SPR for
several purposes. Foremost among these is the authority to
withdraw crude oil to alleviate disruptions and shortages in
the supply of crude oil. Additionally, DOE may conduct
operational ``exchanges,'' ``sales,'' and ``swaps'' for a
variety of purposes, and has been authorized to withdraw crude
oil from the SPR in order to establish a home heating oil
reserve.
1. Emergency Drawdown
As the primary mission of the SPR is to provide a source of
crude oil in the event of a severe disruption in the supply of
crude oil, the EPCA authorizes what is called a ``drawdown''
upon a finding by the President that there is a ``severe energy
supply interruption.'' Under the EPCA, a ``severe energy supply
interruption'' occurs when: (a) an emergency situation exists
and there is a significant reduction in supply which is of
significant scope and duration; (b) a severe increase in the
price of petroleum products has resulted from such emergency
situation; and (c) such price increase is likely to cause a
major adverse impact on the national economy.\5\
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\5\ 42 U.S.C.A. Sec. 6241 (d) (1995 & Supp. 2002).
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In 1990, after the Exxon Valdez oil spill interrupted the
supply of Alaskan crude oil, leading to spot shortages and
price increases, Congress provided DOE with additional drawdown
authority. This authority allows more limited withdrawals from
the SPR in the event of a ``domestic or international energy
supply disruption of significant scope or duration,'' and where
the drawdown would significantly reduce the impact of such a
disruption. In these circumstances a Presidential declaration
of a ``severe energy supply interruption'' is not required.
The first and only emergency drawdown of the SPR occurred
at the outset of the Gulf War in 1991, following Iraq's
invasion of Kuwait. On January 16, 1991, immediately after
launching air strikes against Iraq, President George H.W. Bush
declared that an emergency situation existed regarding the
supply of crude oil, and the DOE began to implement a plan to
sell nearly 34 million barrels of crude oil from the SPR.
Because world crude oil prices stabilized before the full
amount of oil was released, only about half that volume--17.3
million barrels--were sold. This is the only time a drawdown
has been ordered by the President pursuant to a declaration of
an emergency under the EPCA.\6\
---------------------------------------------------------------------------
\6\ http://www.fe.doe.gov/spr/spr--facts.shtml, U.S. Dept. of
Energy website.
---------------------------------------------------------------------------
2. Exchanges
The EPCA also authorizes DOE to exchange oil in the SPR for
operational or other purposes. This general authority has been
used three times. In 1996, DOE delivered approximately 900,000
barrels of crude oil from the SPR to the ARCO Pipe Line Company
after ARCO's Seaway Pipeline from the Gulf Coast to Cushing,
Oklahoma was blocked by waxy crude oil. DOE took this action to
provide a continuous flow of crude oil to Midwestern
refineries. In return for the crude oil from the reserve, ARCO
paid the government a fee and replaced the crude oil withdrawn
within 6 months.
In 1988, the Department exchanged 11 million barrels of
heavy Mexican Maya crude oil for a lesser volume of lighter,
higher quality Mexican Olmeca and Isthmus crudes. In June,
2000, the Department agreed to withdraw 500,000 barrels from
the SPR to supply crude oil to CITGO and Conoco refineries
along the Gulf Coast when shipping lanes had been blocked by
the collapse of a commercial dry dock into the shipping channel
leading to the refineries. After the shipping lanes were
restored, CITGO and Conoco replenished the Reserve for the
amounts of crude oil withdrawn.
In the FY 2001 Interior Appropriations Act,\7\ Congress
formally authorized the creation of a home heating oil reserve
for the northeastern region of the United States, with a
capacity up to 2 million barrels. To establish the heating oil
reserve, Congress authorized the DOE to obtain storage capacity
and the refined product through purchase, contract, lease, or
exchange with crude oil from the SPR. In 2000, DOE swapped 2.8
million barrels of crude oil from the SPR in return for 2
million barrels of heating oil for the home heating oil
reserve.
---------------------------------------------------------------------------
\7\ H. Rept. No 348-69, Pub. L. 106-291 (2000).
---------------------------------------------------------------------------
3. Non-Emergency Sales
On three separate occasions in 1996, Congress authorized
the sale of oil from the SPR to raise revenues for the Federal
Government.\8\ In February and March, 1996, the Defense Fuel
Supply Center sold a total of 5.1 million barrels of oil,
through competitive bids, to four oil companies for a total of
$97.1 million, to pay for the unexpected decommissioning of the
Weeks Island SPR site, which had fractured and was in imminent
danger of collapse.
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\8\ DOE SPR website, at http://www.fe.doe.gov/spr/spr--rik.shtml.
---------------------------------------------------------------------------
In late April 1996, the Congress authorized further sales
of Weeks Island crude that had been transferred to other SPR
storage sites, for the explicit purpose of reducing the Federal
deficit. From May through August 1996, the Defense Fuel Supply
Center sold 12.8 million barrels to nine oil companies, through
competitive bids, at an average sale price of $17.81 per
barrel, for a total of $227.6 million.
The same year, Congress authorized the further sale of $220
million worth of crude oil to offset fiscal year 1997
appropriations. Between October and December the Defense Fuel
Supply Center issued contracts for the sale of about 10.2
million barrels, which provided $220 million in revenue for the
U.S. Treasury.
4. The 2000 Swap: Release of 30 Million Barrels
In late September 2000, with crude oil prices nearing
historical highs, stocks of home heating oil at historically
low levels, and winter just around the corner, President
Clinton issued an executive order, pursuant to the limited
drawdown authority under the EPCA, authorizing a ``swap'' of 30
million barrels from the SPR to alleviate a potential heating
oil crisis.
Under the swap, 30 million barrels of SPR oil were released
for bid. Interested parties bid to borrow quantities of not
less than 1 million barrels of oil, and contracts were awarded
based on how much oil bidders offered to return to the SPR
between August 1 and November 30, 2001. ``[B]idders based their
offers on their best models of what it would cost them to
acquire replacement crude, weighed against the benefit to them
of having additional supply at the beginning of the winter.''
\9\
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\9\ Robert Bamberger, CRS Report, Strategic Petroleum Reserve, June
26, 2002.
---------------------------------------------------------------------------
After the release, according to the Congressional Research
Service (CRS), ``it may have been that U.S. willingness to use
the SPR temporarily took the wind out of the speculative
element in the futures market,'' and spot prices fell from
about $37 to $31 per barrel.\10\ It is unclear, however,
whether other political and economic factors also contributed
to the price decrease.
---------------------------------------------------------------------------
\10\ Id.
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Figure II-1 shows the price of crude oil before and after
the two major releases of oil from the SPR, the 2000 swap and
the 1991 emergency drawdown.
[GRAPHIC] [TIFF OMITTED] T5551.011
C. Filling the SPR
1. Initial Fill of the SPR
From the mid-1970's until 1995, when the initial fill of
the SPR was completed, 592 million barrels of crude oil were
placed in the SPR. As of the end of FY 1997, the cumulative
cost of the crude oil purchased to supply the SPR was nearly
$16 billion. Table II-1 shows the sources of oil deposited into
the SPR through 2001:
[GRAPHIC] [TIFF OMITTED] T5551.001
From 1995 through 1998, the total inventory of crude oil in
the SPR declined due to the sale of crude oil from the SPR and,
with a ballooning Federal deficit and relatively stable crude
oil supplies, new expenditures were postponed and alternative
methods of adding crude oil to the SPR explored.
2. Recent and Current Programs to Fill the SPR
Recently, DOE has been depositing crude oil into the SPR
under three programs: (1) contracts to replace the 30-million
barrels released in the fall of 2000; (2) contracts under the
1999 Royalty-in-Kind (RIK) program designed to replace the 28
million barrels withdrawn in the 1996 sales; and (3) contracts
to deliver additional crude oil under the RIK program pursuant
to the President's November 2001 announcement to fill the SPR
to 700 million barrels. These programs are listed in Table II-2
and described below.
[GRAPHIC] [TIFF OMITTED] T5551.002
a. 2000 Swap Refill
Under the original schedule for returning the 30 million
barrels of crude oil taken from the SPR in the September 2000
swap, these barrels were to be returned between August 1 and
November 30, 2001. In late March 2001, DOE renegotiated the
schedule for the return of 24 million of these barrels. Under
the new schedule, the return of these 24 million barrels would
occur between December 2001 and January 2003, and the companies
returning the oil would provide a total of 3.5 million
additional barrels to compensate the SPR for the schedule
extension. As of February 2003, about 28 million of these
barrels have been returned. An additional 6 million barrels are
scheduled to be returned in 2003.
b. 1999 Royalty-In-Kind (RIK) Program
In order to avoid additional Federal outlays for the
purchase of crude oil to fill the SPR, in 1999, the Clinton
Administration initiated the royalty-in-kind (RIK) program.\11\
Traditionally, the Federal Government, through a program
managed by the Department of Interior's Minerals Management
Service (MMS), has collected royalty fees, in cash, for crude
oil produced from offshore crude oil and gas wells operating
under leases on the federally-owned Outer Continental Shelf.
Under the RIK program, the Federal Government obtains crude oil
for the SPR as ``in-kind'' royalties--rather than financial
payments--from these oil leases. This allows the Federal
Government to fill the SPR without using appropriated funds to
purchase the oil.
---------------------------------------------------------------------------
\11\ The RIK program is described in the DOE's Office of Fossil
Energy website at http://www.fe.doe.gov/spr/spr--rik.shtml.
---------------------------------------------------------------------------
To begin the RIK process, the MMS announces a bidding
competition for the transportation of royalty oil that will be
due to the Federal Government from the crude oil produced on
tracts leased by the Federal Government in the Gulf of
Mexico.\12\ This competition is essentially a bidding contest
for the transportation of the royalty oil from the company's
wellhead in the Gulf to the ``market center'' designated by the
MMS. Generally, the successful bidder will be the company
offering the MMS the largest portion of the oil delivered to
the market center, and taking the least amount of the oil
itself as payment for the transportation of the oil to the
center.
---------------------------------------------------------------------------
\12\ The sale is based on a competitive bidding process.
If the minimum bid price is not met, MMS will have the option to
negotiate prices with the highest bidder. http://www.mrm.mms.gov/
RIKweb/PDFDocs/51626.pdf.
---------------------------------------------------------------------------
Because the royalty oil from the Gulf of Mexico leases is
not of sufficient quality to be deposited in the SPR, DOE runs
an additional, separate competition for contracts to exchange
the royalty oil in the market centers for crude oil to be
delivered to the SPR. The competition calls for bidders to take
the royalty oil at the market center, swap it for oil suitable
for the SPR, and then transport the SPR-suitable oil to the
SPR. Generally, the successful bidder will be the company that
promises to deliver the most barrels into the SPR in exchange
for the royalty barrels taken from the market center.
Because a variety of crude oils are acceptable to place in
the SPR, the DOE may also consider the quality of the crude oil
offered to be placed into the SPR as a factor in determining
which bid to select.\13\ The quality of the oil to be deposited
may be of particular significance when the leading bidders are
offering approximately the same volumes to be deposited.
---------------------------------------------------------------------------
\13\ Interview with DOE officials by Subcommittee staff on June 12,
2002.
---------------------------------------------------------------------------
In 1999, the RIK program was adopted as a means to refill
the SPR for the 28.1 million barrels withdrawn during the 1996
sales, without additional Federal outlays. The refills under
this program began in the spring of 1999, and were to continue
through January 2003, by which time the SPR was to have
received a total of 30.7 million barrels.
Although the RIK program enables the SPR to be filled
without Federal outlays, using RIK oil for the SPR program
nonetheless affects the Federal budget. The exchange of royalty
oil for SPR oil deprives the Federal treasury of revenues that
otherwise would have accrued had the MMS sold the royalty oil
on the open market. Exchanging royalty oil for SPR oil when oil
prices are high, therefore, results in a greater loss to the
Treasury than exchanging royalty oil for SPR oil when oil
prices are low. Hence, to the extent that the SPR program uses
RIK oil when prices are high rather than low, taxpayers pay
higher costs for the SPR, just as if the crude oil placed in
the SPR had been bought on the open market at those high
prices.
c. L2001 RIK Program to Fill the SPR to 700 Million Barrels
The increased national security concerns and falling crude
oil prices that followed the terrorist attacks on the United
States in September 2001, led both the Congress and the
Administration to support filling the SPR to capacity. In
October 2001, the House of Representatives passed a resolution
supporting the filling of the SPR to its maximum authorized
level of 1 billion barrels.\14\ In April 2002, the Senate
passed an energy bill that included language to permanently
authorize the SPR and require DOE to fill to its current
capacity of approximately 700 million barrels.\15\
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\14\ H.Res. 250, 107th Cong., 1st Sess., A Resolution Urging the
Secretary of Energy to Fill the Strategic Petroleum Reserve.
\15\ The Senate passed the energy bill, H.R. 4, on April 25, 2002,
but it was never enacted into law.
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In November 2001, President Bush announced the
Administration's intent to fill the SPR to its current 700
million barrel capacity.\16\ In the announcement, the President
directed the Secretary of Energy to fill the SPR ``in a
deliberate and cost-effective manner.'' \17\ In a
contemporaneous DOE press release, DOE stated, ``The
President's decision will expand an ongoing `royalty-in-kind'
program, adding oil to the Reserve in a deliberate and cost-
effective manner at rates of up to 130,000 barrels per day
beginning [in 2002].'' \18\
---------------------------------------------------------------------------
\16\ http://www.fe.doe.gov/spr/spr--rik.shtml.
\17\ President Orders Strategic Petroleum Reserve Filled, Statement
by the President, at http://www.whitehouse.gov/news/releases/2001/11/
20011113.html.
\18\ DOE Press Release, President Directs Energy Secretary to
Increase Strategic Reserve, November 13, 2001.
---------------------------------------------------------------------------
On January 22, 2002, DOE announced a solicitation for bids
to exchange up to 22 million barrels of royalty oil for oil to
fill the SPR.\19\ ``Because Strategic Reserve crude oil
typically exceeds the quality of most offshore crudes,'' DOE
stated, ``companies will likely deliver somewhat less than the
22 million barrels of royalty oil to the Reserve after
adjusting for the quality differences. The companies can also
make adjustments to account for their costs to deliver oil to
the Reserve sites. The Energy Department will negotiate
contracts with the companies that offer the ratios most
favorable for the U.S. Government.'' \20\
---------------------------------------------------------------------------
\19\ DOE Press Release, Energy Department Opens Bid Process to
Begin Filling Strategic Oil Reserve, January 22, 2002.
\20\ Id.
---------------------------------------------------------------------------
On February 6, 2002, DOE awarded this RIK contract to
Equiva Trading Company, which has since become part of Shell.
Under this contract, Equiva agreed to deliver 18.6 million
barrels of sweet crude oil to the SPR through the RIK program
between April 1, 2002, and May 1, 2003.\21\ This contract
translates to a fill rate of approximately 60,000 barrels per
day. Publicly announcing the award 5 days later, on February
11, 2002, the Secretary of Energy stated, ``Today's
announcement is another step forward in the President's efforts
to strengthen the nation's energy security. . . . The Strategic
Petroleum Reserve is one of our most important strategic
assets, and today's action ensures that we will be prepared for
potential supply disruptions in the future.'' \22\ Shell began
delivery of oil to the SPR under this contract in April 2002.
---------------------------------------------------------------------------
\21\ DOE anticipates that after this contract terminates in 2003,
subsequent RIK contracts will specify that two-thirds of the oil
deposited under the contract be sour crude and one-third be sweet
crude. DOE interview with Subcommittee staff.
\22\ http://www.fe.doe.gov/techline/tl--sprrik2002--equiva.shtml.
---------------------------------------------------------------------------
In late July 2002, DOE announced a new RIK contract
solicitation to increase the fill rate by about 40,000 barrels
per day. ``More oil in the Reserve is more energy insurance for
American consumers,'' the Secretary of Energy stated. ``And the
faster we can add oil to the Reserve, the more energy security
we can provide for all Americans.'' \23\ On August 11, 2002,
DOE announced that Koch Supply and Trading had won the bidding
for this contract. Under the contract, Koch agreed to supply
approximately 8 million barrels of crude to the SPR, with
deliveries beginning October 1, 2002, and running through April
30, 2003.\24\
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\23\ Fossil.Energy.gov Techline, Administration to Increase Fill
Rate of Strategic Petroleum Reserve, July 26, 2002, at http://
www.fe.doe.gov/techline/tl--spr--rik2002--phase2.shtml.
\24\ Office of Fossil Energy website, at http://www.fe.doe.gov/spr/
spr--rik.shtml.
---------------------------------------------------------------------------
On February 10, 2003, DOE announced the award of three new
contracts to place, on average, another 116,000 barrels per day
into the SPR over a 6-month period beginning in May 2003. On
the same date DOE also announced that in April it would begin
pumping about 15,000 barrels per day of crude from producers
off the Texas coast into the SPR. According to DOE, ``The
combined shipments will boost the Strategic Petroleum Reserve's
fill rate to approximately 131,000 barrels per day--the fastest
since President Bush announced plans in November 2001 to fill
the Reserve to its full 700-million barrel capacity. . . . ``
\25\ The contracts announced in February will add another 24
million barrels to the SPR between April and October, 2003.
---------------------------------------------------------------------------
\25\ DOE, New Contracts Awarded for Planned Spring Acceleration of
Oil Fill for Strategic Petroleum Reserve, February 10, 2003, at http://
www.fe.doe.gov/techline/tl--spr--rik2003--sel.shtml.
---------------------------------------------------------------------------
As of the writing of this Report in March 2003, the total
volume of oil stored in the SPR is about 600 million barrels.
As shown in Figure II-2, this total includes the steady
addition of over 40 million barrels of oil from November 2001
through September 2002.
[GRAPHIC] [TIFF OMITTED] T5551.012
Current SPR contracts call for depositing an additional 43
million barrels in 2003, at a steady rate of over 130,000
barrels per day. Table II-3 provides the current monthly
schedule for future SPR deliveries.
[GRAPHIC] [TIFF OMITTED] T5551.003
3. Strategy for Filling the SPR
a. Different Types of Crude Oil May Be Placed in the SPR
For each of the two basic types of crude oil stored in the
SPR--sweet and sour crudes--DOE allows SPR contractors to
deposit a variety of crude into the reserve, as long as they
meet DOE's minimum standards for that specific type of crude
oil. Providing contractors with flexibility in the types of
crude oil that can be delivered to the SPR is one measure taken
by the SPR program to minimize costs and market disruptions.
Table II-4 shows the thirteen different types of oil that meet
DOE's specifications for sweet crude oil:
[GRAPHIC] [TIFF OMITTED] T5551.154
Although DOE provided its SPR contractors with the option
to deposit a variety of sweet crudes into the SPR, from the
fourth quarter of 2001 through the first half of 2002, oil
companies chose to deposit into the SPR large amounts of Brent
crude oil, a crude oil dwindling in supply and the price of
which serves as a benchmark for the price of other crude oils.
Figure II-3 shows the breakdown between Brent and other
sweet crudes deposited into the SPR from April 1999, when the
filling of the SPR recommenced under the 1999 RIK program,
through September 2002. This investigation's findings regarding
the significant consequences arising from these large deposits
of Brent crude oil into the SPR, including the effect upon
global crude oil markets and crude oil prices in the United
States, are explained in Section IV.
[GRAPHIC] [TIFF OMITTED] T5551.013
b. Market-Based Acquisition Strategy and Fill Schedules
DOE solicitations for oil to be deposited into the SPR
provide a general time period for the delivery of the oil to
the SPR. After a solicitation is awarded, the contractor
proposes a more specific schedule of deliveries. DOE and the
contractor then establish a mutually acceptable schedule.\26\
---------------------------------------------------------------------------
\26\ Typically, after a SPR fill contract is awarded, DOE will
delay for several days the public announcement of the winning bidder in
order to allow the winning bidder to prepare to implement the contract
prior to the market learning of the general requirements of the
contract. Even after publicly announcing the award of a contract, DOE
withholds significant information from the market to ensure that
persons other than the contract participants do not obtain advance
knowledge of SPR purchase and shipping schedules. DOE also withholds
details about the various bids received, why a certain bidder won, and
the specific delivery schedule under the contract. DOE reveals only who
the winning bidder is, and how much oil will be delivered into the SPR
on a monthly basis. DOE withholds this contract, delivery, and bid
information in part to prevent actions by crude oil market participants
that could increase a contractor's transportation costs or ``squeeze''
the contractor by bidding up the price of oil suitable for the SPR.
---------------------------------------------------------------------------
The SPR program's ``Business Procedures,'' Exhibit II-1,
most recently issued in January 2002, provide DOE and SPR
contractors flexibility to modify delivery schedules, either by
deferring or accelerating deliveries, depending on market
conditions.\27\ DOE has publicly stated that it used these
business procedures to deposit more oil into the SPR when crude
oil markets are ``weak,'' and delay deliveries when the markets
are ``strong,'' both to minimize SPR program costs and to help
stabilize crude oil markets.
---------------------------------------------------------------------------
\27\ Strategic Petroleum Reserve, Business Procedures, Crude Oil
Exchanges, January 2002; Exhibit II-1.
---------------------------------------------------------------------------
If a contractor asks to defer or advance a shipment, DOE
will require the contractor to compensate DOE for any loss in
value from the change in schedule. The SPR Business Procedures
state:
During contract performance there may be situations
when due to programmatic requirements or through
contractor request the schedule for the delivery of
exchange oil to the SPR sites are proposed to be
deferred to a later date or accelerated to an earlier
date. An evaluation is performed incorporating a
formula that encompasses market conditions including
crude oil prices from contracted delivery period to the
revised delivery period, time value of money, and crude
type differentials. Based on this evaluation
negotiations are conducted with the contractor [and DOE
personnel]. Based on the negotiated agreement a
bilateral modification is executed [by DOE] and the
contractor incorporating the revised delivery schedule;
[and] any additional premium barrels owed by the
contractor as a result of the agreement. . . .\28\
---------------------------------------------------------------------------
\28\ Id., at page 6.
According to a September 2001 presentation, Exhibit II-2,
prepared by the SPR Office for other countries considering
establishing a crude oil reserve program, ``the key to a
successful strategic reserve is cost control.'' \29\ Because
``the number and extent of future disruptions is unknown,'' and
``measuring the degree of damage from a disruption, and the
consequent benefits of a petroleum reserve, to an individual
economy is an uncertain science,'' DOE states that ``cost is
the easiest aspect to control and has the highest probability
of making the Reserve cost beneficial.'' According to the
presentation, the major costs for the SPR program are the
capital costs to construct the facility, the costs to operate
and maintain the Reserve, and the costs of acquiring the oil
for the Reserve.
---------------------------------------------------------------------------
\29\ Presentation by John Shages, DOE Office of Strategic Petroleum
Reserve, Asia-Pacific Economic Cooperation Energy Working Group,
Workshop on Energy Security Policy, Sept. 14-15, 2001; Exhibit II-2.
---------------------------------------------------------------------------
According to the same presentation, DOE follows four
market-based principles when filling the SPR. In a chart
entitled, ``Lessons Learned to Control Oil Acquisition Costs,''
DOE describes these principles as follows:
Let the markets determine your buying pattern.
Buy in weak markets.
Delay deliveries during strong markets.
Use your acquisition strategy to stabilize
markets.\30\
---------------------------------------------------------------------------
\30\ Id.
By calling them ``Lessons Learned,'' DOE indicates that these
principles were developed as a result of previous program
experience. Essentially, they direct DOE to buy more oil when
current market prices are low, and less when oil prices are
high.\31\
---------------------------------------------------------------------------
\31\ More precisely, the terms ``weak'' and ``strong'' market
appear to refer to when the market is in contango (near-term prices
lower than longer-term prices) or in backwardation (near-term prices
higher than longer-term prices), respectively. See also internal SPR
memorandum, Exhibit V-4.
---------------------------------------------------------------------------
In 2000 and 2001, DOE regularly followed these market-based
principles. For example, in March 2001, DOE postponed the
delivery of 24 million barrels of crude oil then scheduled to
be delivered between August and November 2001, until sometime
between December 2001 and January 2003. In return for the
delay, DOE obtained an additional 3.5 million barrels.
According to the Congressional Research Service, ``It is
believed that the schedule was renegotiated to keep pressure
off crude markets, and to keep this volume of oil in the
private sector where it can be tallied in industry stocks going
into the winter of 2001-2002.'' \32\ The available futures
market data indicates that at the time of DOE's decision, crude
oil futures markets were backwardated, meaning near-term prices
were greater than longer-term prices.
---------------------------------------------------------------------------
\32\ Robert Bamberger, CRS Report, Strategic Petroleum Reserve,
June 26, 2002.
---------------------------------------------------------------------------
Similarly, the original schedule for the 1999 royalty-in-
kind program called for delivery of just over 27 million
barrels to the SPR throughout the year 2000. DOE obtained an
additional 3.6 million barrels in return for extending the
delivery schedule to run through 2002.
In total, these two extensions resulted in an additional 7
million barrels for the SPR, at no additional taxpayer cost.
Based on the average spot price of crude oil in 2002 at $26 per
barrel, these deferrals reduced SPR costs by over $175
million.\33\
---------------------------------------------------------------------------
\33\ See Exhibit V-4. DOE's calculation of savings are based upon
an average price of $25 per barrel. This is a slight underestimation,
since the average spot price for WTI in 2002 was just over $26 per
barrel, which means taxpayer savings were actually closer to $180
million.
---------------------------------------------------------------------------
c. SPR Market-Based Procedures Abandoned
In February 2002, DOE abandoned its market-based business
procedures, and instituted a policy of denying all requests for
deferrals of scheduled SPR deposits, regardless of market
conditions. The decision to stop granting requests for
deferrals, regardless of the price of oil, was announced by the
Secretary of Energy after consulting with White House and other
high-ranking Administration officials. SPR career officials
warned that this change in strategy would lead to lower
commercial crude oil inventories and higher prices, and
unsuccessfully recommended a return to a market-based program.
Sections IV and V of this Report detail the consequences of
the no-deferral policy that was adopted in 2002. Section IV
explains how the refusal to grant deferrals in early 2002 led
to a squeeze in the market for Brent crude oil, which in turn
led to price spikes in the U.S. crude oil market, costing
American consumers and businesses between $500 million and $1
billion in 1 month alone. Section V describes the concerns of
the SPR career officials regarding the new no-deferral policy,
and how the Administration's market-blind policy also led to
higher crude prices and lower commercial inventories, resulting
in no net increase in national oil supplies.
III. THE PRICING OF CRUDE OIL
``Leon Hess, whose oil company made more than $200
million by trading oil futures during the Persian Gulf
crisis . . . said he longs for the days when oil
company barons could get together and decide prices and
supply levels largely among themselves, rather than
depending on the violent price swings created by
traders who react to rumors and headlines.
`` `I'm an old man, but I'd bet my life that if the
Merc [New York Mercantile Exchange] was not in
operation there would be ample oil and reasonable
prices all over the world, without this volatility,'
Hess said at a hearing the Senate Committee on
Governmental Affairs held on the role of futures
markets in oil pricing.''
--``LOil Baron Longs for Past, Not Futures,''
Newsday, November 2, 1990
In 2002, the price of crude oil in the United States nearly
doubled, climbing from $18 per barrel in January to over $34
per barrel in December. Since then, crude oil prices continued
to climb and recently reached a 12-year high of nearly $40 per
barrel.\34\ Gasoline, home heating oil, jet fuel, and diesel
fuel prices also have increased dramatically over this period.
---------------------------------------------------------------------------
\34\ The price of West Texas Intermediate crude oil on the New York
Mercantile Exchange reached $39.99 on February 27, 2003.
---------------------------------------------------------------------------
To understand how filling the SPR became a major factor
driving up oil prices, it is first necessary to understand how
crude oil prices are determined in today's markets.
The crude oil market is the largest commodity market in the
world. The nations of the world consume approximately 70-80
million barrels of crude oil each day. To meet that demand,
each day, hundreds of millions of barrels are traded on the
crude oil spot, futures, and over-the-counter markets, with
several times the world's production of crude oil traded daily
on the New York and London futures exchanges, and contracts
worth hundreds of millions of dollars traded daily on the over-
the-counter markets. The United States is the single largest
consumer of crude oil, consuming about one quarter of the
world's production of crude oil, amounting to about 18 million
barrels per day. The United States is also the largest crude
oil purchaser and importer, importing about 60 percent of its
oil needs, or about 10 million barrels per day. In the United
States, most of this crude oil, approximately 90 percent, is
refined into fuel products, such as gasoline, home heating oil,
jet fuel, and diesel fuel.
Crude oil prices today are heavily influenced by producers,
consumers, and traders buying and selling oil contracts or
related financial instruments in various markets for crude oil.
The development of a market-based system for determining the
price of crude oil is a relatively recent advance in the
petroleum industry.\35\ Prior to the mid-1970's, crude oil
prices were largely determined by fiat by a few large oil
companies dubbed the ``Seven Sisters.'' Following the
nationalization of many of the Middle Eastern oil fields owned
by these companies and the rise in power of the Organization of
the Petroleum Exporting Countries (OPEC) cartel, crude oil
pricing shifted from private companies to OPEC, which
effectively controlled global prices from the mid-1970's until
the mid-1980's. A variety of political and economic factors,
including falling demand for crude oil and rising production by
non-OPEC members, precipitated a collapse of the OPEC
administered pricing system in the mid-1980's and the
development of a market-based pricing system.
---------------------------------------------------------------------------
\35\ See, e.g., Robert Mabro, Oil Markets and Prices, Oxford
Institute for Energy Studies, Monthly Comment, August 2000.
---------------------------------------------------------------------------
Nearly all commodity and financial markets have changed
significantly since the mid-1980's, largely as a result of the
revolutions in computer, communications, and information
technology. The crude oil markets are no exception. Over the
past 20 years, trading volumes on the crude oil futures
exchanges have greatly increased, and in the past few years
electronic over-the-counter (OTC) markets have emerged to rival
the traditional futures markets.
This section of the Report provides an overview of the
crude oil markets, including the spot, futures, and OTC
markets. It describes the three ``benchmark crudes,'' which are
used as a basis for the price of crude oils sold around the
world, the major types of contracts by which crude oil is now
sold and purchased, and the pricing mechanisms and related
financial instruments that are now commonly used in futures and
OTC markets. This section also outlines the varying degrees of
regulation of the different crude oil markets in the United
States, contrasting the extensive regulation of the futures
exchanges with the near absence of regulation of trading in OTC
markets.\36\
---------------------------------------------------------------------------
\36\ More detailed information on the regulation of commodity
markets, including the crude oil markets, is provided in Appendices 1
and 2.
---------------------------------------------------------------------------
This section also describes in greater detail the markets
for the three crude oils that serve as price benchmarks for all
other types of crude oil--Brent, West Texas Intermediate (WTI),
and Dubai. Additional detail is provided about the Brent
market, including how the Brent spot, futures, and OTC markets
interact and affect each other's prices. The section also
describes how the so-called ``Arcadia squeeze'' of the Brent
market in 2000 dramatized the Brent market's susceptibility to
manipulation. This vulnerability continued for the next 2
years, until Brent market corrections were made in mid-2002.
Understanding the Brent market, its vulnerability to
squeezes, and its relationship to other crude oil markets, such
as the U.S. market for WTI, is critical to understanding how
depositing significant amounts of Brent into the SPR in late
2001 and the first half of 2002 became a major factor driving
up crude oil prices in the United States.
A. Overview of Crude Oil Markets
Crude oil prices are largely determined by supply and
demand conditions in the global oil market, reflecting numerous
transactions between buyers and sellers taking place around the
world.
Most of the world's crude oil is located within the
boundaries of the countries belonging to OPEC, and OPEC has
nearly all of the world's estimated excess production capacity.
OPEC attempts to set an average global price for crude oil by
establishing production quotas for its members and meets
regularly to adjust these quotas in consideration of the global
balance between supply and demand. Because of its market power,
OPEC decisions about the supply of oil significantly affect
world oil prices. Nonetheless, its efforts have met with
varying degrees of success, as OPEC members often have
conflicting objectives and do not always adhere to the quotas,
and production by non-member countries has increased in recent
years. Economists disagree as to the effectiveness of OPEC as a
cartel.
Global price levels are also affected by the level of
inventories of crude oil and petroleum products in oil-
consuming countries. When inventories are high, supplies are
more plentiful, and prices tend to fall. Lower inventories mean
tighter market supplies, which, in turn, push prices upward to
bring more oil into the market.
Oil prices also depend on the supply and demand for the
various types of crude oil produced in different oil fields.
Crude oil streams with a low sulfur content (``sweet'' crudes)
or that are less dense (``light'' crudes) than heavier crude
oils are easier to process into the more valuable refined
products, such as gasoline. To efficiently process the heavier
crudes into lighter products, refiners must install additional,
expensive refining equipment. Generally, therefore, light,
sweet crudes are more expensive than heavy, sour crudes.
Different refiners have adopted different strategies as to
whether to make significant capital investments for more
processing equipment in order to refine the cheaper heavier,
sour crudes, or whether to forego the capital expenditures and
continue to pay a premium for light, sweet crude oil. The price
differential between light, sweet crudes and heavy, sour crudes
at any given time depends on the relative capacity within the
refining industry for processing these two types of crudes, the
supplies of these crude oils, as well as the relative demand
for lighter and heavier refined products.
The global crude oil market consists, therefore, of a
number of sub-markets for crude oil, which are influenced by
the characteristics of those crude oil streams, and the supply
and demand balance for those particular types of crude oil. The
price for any particular crude oil stream may deviate by as
much as several dollars per barrel from the OPEC target or the
global average, depending on the quality of the crude oil, the
supply and demand situation in that particular sub-market, and
local political and economic factors.
Crude oils produced in the oil fields around the world are
grouped into several hundred separate crude oil streams. Almost
all of these crude oil streams are priced in relation to the
prevailing market price of one of the three ``benchmark''
grades of crude oil--Brent crude oil produced in the North Sea
territorial waters of the United Kingdom, West Texas
Intermediate (WTI) produced near the U.S. Gulf Coast, and Dubai
crude oil produced in the Middle East. Typically, other crude
oil streams are priced at either a premium or a discount to the
relevant benchmark price, depending on the quality of the oil
relative to the benchmark.\37\ The benchmark used for a
particular purchase will depend upon the type of crude oil
being purchased and the location of the purchaser.
---------------------------------------------------------------------------
\37\ Benchmark pricing is discussed in more detail infra.
---------------------------------------------------------------------------
There are several different types of markets for crude oil
and related financial products. Most of the crude oil that is
purchased for delivery is done pursuant to either a fixed-term
contract or on the ``cash'' or ``spot'' market. There are also
two well-established futures markets for crude oil, the New
York Mercantile Exchange (NYMEX) and London's International
Petroleum Exchange (IPE), but futures contracts rarely result
in actual delivery of crude oil. The futures markets serve
mainly to spread the risks of price volatility and for price
discovery.
In addition, there is an extensive over-the-counter (OTC)
market for various types of crude oil contracts and a host of
related financial instruments. Many of these financial
instruments, such as swaps, serve to spread financial risk and
discover prices, in the same manner as futures contracts. OTC
transactions either are negotiated directly between OTC market
participants, over the telephone through brokers, or,
increasingly, on electronic exchanges.
1. Term Contracts
Much of the world's crude oil is bought and sold using two-
party ``term contracts'' covering multiple transactions over a
specified length of time. These contracts specify the volumes
to be delivered for the duration of the contract and fix the
method for calculating the price of the oil. Although these
contracts can cover as few as one shipment of oil or last as
long as several years, they typically cover a number of
shipments over a 1-year period, and provide an option for
renewal upon expiration. The contracts may also provide for
different amounts of crude oil to be delivered at different
times in the contract period.
Term contract prices are usually tied to the price of one
of the three benchmark crude oils, plus or minus a quality
adjustment. Crude oil delivered into the U.S. Gulf Coast
usually is priced in reference to the price of West Texas
Intermediate (WTI) crude oil. Crude oil delivered into European
markets or produced in West Africa usually is priced in
reference to Brent crude oil. Crude oil delivered into Asia or
the Middle East normally is priced in reference to the price of
crude oil produced Dubai and Oman.
[GRAPHIC] [TIFF OMITTED] T5551.014
Term contracts for the sale of crude oil priced in relation
to a benchmark also typically contain a ``quality adjustment,''
which is a negotiated dollar amount reflecting the difference
in quality between the oil being purchased and the quality of
the benchmark oil. Most often, the value of the quality
adjustment will be fixed for the duration of the contract.
Crude oil purchased under a term contract is usually tied to
the spot price of the specified benchmark at the time the
seller loads the crude oil into a cargo ship for transport to
the purchaser.
Term contracts are negotiated through face-to-face
meetings, or by telephone and fax, and are customized to the
particular needs of the contract participants. These contracts
are not traded on regulated exchanges or over-the-counter.
2. Crude Oil Spot or Cash Market
The crude oil spot market, also known as the ``cash''
market, is not a formal exchange like the NYMEX but rather an
informal network of buyers and sellers. The spot market
provides a market to dispose of or buy an incremental supply of
crude oil not covered by contractual agreements, in response to
the market's current supply and demand conditions. Rising
prices on the spot market indicate that demand is high and more
supply is needed, while falling prices indicate there is too
much supply for the market's current demand level.
A spot market transaction is an agreement to buy or sell
one shipment of crude oil at a price negotiated at the time of
the agreement. The crude oil may be delivered immediately, or
it may be delivered at some specified time in the future, in
which case the contract is also known as a ``forward''
contract. Typically, spot market transactions are priced at the
time the crude oil is loaded at the terminal for shipment.
The spot prices of the three major benchmark crudes--Brent,
WTI, and Dubai--serve as indicators for all of the crude oils
bought and sold on the spot market. The spot price is typically
guided by the prices of other recent spot transactions, as
reported in Platts and other trade publications, and by
reference to the futures prices quoted on the NYMEX for WTI or
on the IPE in London for Brent.
Since the middle of the 1980's, increasing amounts of crude
oil have been bought and sold on the worldwide spot market.
Before 1979, less than 3 percent of all crude oil traded
worldwide was traded on the spot market. By 1989, it was
estimated that about one-third of all crude oil was traded on
the spot market.\38\
---------------------------------------------------------------------------
\38\ General Accounting Office, GAO/RCED-93-17, 37; Platts Oilgram
Price Report, November 28, 2001; and DOE/EIA.
---------------------------------------------------------------------------
Term contracts and spot market transactions are the leading
mechanisms for arranging for the physical delivery of crude
oil. In the United States, term contracts and spot market
transactions for crude oil are commercial transactions subject
to state and Federal law. Because neither type of transaction
is considered a contract for future delivery, neither is
subject to regulation under the Commodity Exchange Act (CEA),
which regulates contracts for future delivery. Although the CEA
makes it illegal to manipulate ``the market price for any
commodity,'' in practice the Commodity Futures Trading
Commission (CFTC) will scrutinize spot market transactions only
in connection with an investigation of alleged misconduct
involving the futures market. In short, crude oil term
contracts and spot transactions are important mechanisms for
the delivery of crude oil yet are not subject to commodity
market regulation.\39\
---------------------------------------------------------------------------
\39\ Subcommittee interview with CFTC staff.
---------------------------------------------------------------------------
3. Crude Oil Futures Markets
While term contracts and spot transactions involve the
trade of physical barrels of oil for immediate or deferred
delivery, the futures markets involve the purchase and sale of
contracts for the future delivery of crude oil. A ``futures
contract'' is a standardized contract by a buyer to accept and
a seller to deliver a given quantity of a particular commodity
at a specified place, price, and time in the future. For
example, the standard crude oil futures contract traded on the
NYMEX specifies 1,000 barrels of WTI crude oil to be delivered
at Cushing, Oklahoma, at a specified date in a future
month.\40\ By law, futures contracts generally must be traded
on regulated commodity exchanges.\41\
---------------------------------------------------------------------------
\40\ The contract actually provides for the delivery of several
types of domestic and foreign crude oil streams, with either a discount
or premium per barrel based on the specific crude the seller delivers.
The standard NYMEX light sweet crude contract lists the specifications
of the deliverable grades of crude oil with the specified discounts and
premiums. This contract may be traded within a 30-month period prior to
the date of delivery specified in the contract for the oil. NYMEX also
offers standard light, sweet crude contracts for delivery of WTI crude
oil 3, 4, 5, 6, and 7 years into the future.
\41\ Exceptions to this general rule are discussed later in this
Section and in Appendix 2.
---------------------------------------------------------------------------
Rather than provide a mechanism for the actual delivery of
physical volumes of crude oil, however, the primary purposes of
futures contracts are to allow market participants to spread
the risk of price volatility and to provide a mechanism for
price discovery. Indeed, one of the major differences between a
forward contract and a futures contract is that in the former
delivery is intended whereas in the latter it is not.\42\
---------------------------------------------------------------------------
\42\ See Commodity Futures Trading Comm. v. Co Petro Marketing
Group, Inc., 680 F.2d 573 (9th Cir. 1982).
---------------------------------------------------------------------------
The first function of a futures contract, risk spreading,
occurs as producers and consumers buy or sell futures contracts
that fix the price of future purchases or sales and thereby
reduce the risk of price volatility and uncertainty prior to
delivery. For example, a producer of crude oil may be concerned
that the price of crude may fall in the future. At the same
time, a refiner may be concerned that the price of crude may
rise. By entering into a futures contract that fixes the price
of crude oil to be delivered in the future, both the producer
and the refiner can protect themselves against adverse price
movements. Alternatively, a speculator may be willing to enter
into a futures contract with either a producer or a refiner and
be willing to bear the risk of a price movement in return for
the possibility of speculative gains from those price changes.
A broad range of participants in the oil industry use the
futures markets. In addition to crude oil producers and
refiners, oil trading firms, petroleum-product end users,
financial institutions, and investment funds also account for
significant trading volume. For example, a number of airlines
use crude oil futures to hedge the cost of jet fuel. A number
of investment banks use crude oil and other energy-related
futures to hedge against changes in energy costs, which affect
many of their other investments.
[GRAPHIC] [TIFF OMITTED] T5551.149
The second function of the futures market, price discovery,
occurs as market participants bring to the marketplace their
knowledge of current supply and demand conditions and their
expectations about the future. Prices change frequently as the
participants revise or reevaluate their expectations on the
basis of new information, and buy and sell futures contracts in
accordance with those expectations. As a futures contract
approaches the delivery date, the price of the first forward
month should approach the spot price.
Basic Terms Used in Futures Markets:
A purchaser of a futures contract that provides for
delivery of a commodity to the holder of the contract
at a future date is said to be long in the commodity.
The holder of a futures contract that requires the
contract holder to deliver the commodity at a future
date is said to be short in that commodity. At any
given time, the number of shorts must exactly balance
the number of longs. Because futures contracts are not
generally used to obtain or deliver actual commodities,
holders of futures contracts generally will square out
their positions (i.e., buy back from the market the
amount of the commodity that previously had been sold,
or sell back to the market that which previously had
been bought) before the expiry of the contract, meaning
the date on which the contract expires, at which time
the remaining holders of outstanding contracts will be
required to accept or make physical delivery of the
commodity. See, e.g., Chicago Board of Trade,
Agricultural Futures and Options (1998).
Standardized Contracts
The standardization of futures contracts facilitates the
trading of these contracts, which is one of the major
advantages of purchasing a contract that can be traded on an
exchange. Typically, to execute a trade involving a
standardized futures contract on an exchange, the only
contractual term that must be negotiated for the sale or
purchase of that contract is the price. On a commodities
exchange, this takes place through either the open outcry
system, which is the traditional system of traders and brokers
signaling and shouting to each other bids and offers in trading
pits located on the exchange floor, or through an electronic
exchange, where the bids and offers are posted and matched
electronically, without any face-to-face contact between the
parties or their brokers. The NYMEX uses the open outcry system
for trading crude oil and other commodity contracts, whereas
the IPE plans to discontinue pit trading and switch to all-
electronic trading.
Because the contracts are standardized, a single futures
contract can be traded many times before the delivery date
specified on the contract, each time at a new price as the
market's supply and demand situation changes. Since futures
contracts rarely are used to obtain or make physical delivery,
the volume of crude oil traded under these contracts can far
exceed the actual available volumes of the underlying
commodity. In fact, in recent years the total volume of crude
oil represented in open NYMEX light sweet crude oil contracts
typically has been over 110 times the daily production of all
crude grades deliverable under the contract.\43\ On average,
less than one-tenth of 1 percent of these oil futures contract
results in the actual delivery of crude oil. For example, over
the 7 years that the December 2001 NYMEX light sweet crude oil
contract was traded, 5 billion barrels were traded, but only
31,000 barrels were actually delivered on those contracts.\44\
---------------------------------------------------------------------------
\43\ Information provided to Subcommittee staff by NYMEX.
\44\ Id.
---------------------------------------------------------------------------
Futures trading of crude oil on NYMEX began in 1983, and
today the volume of the WTI crude oil futures contract traded
on the NYMEX is the largest of any physical commodity traded in
any futures market. For example, in 2001, over 37.5 million
crude oil futures contracts--each for 1,000 barrels of WTI
crude oil--were traded on the NYMEX.\45\ Although the NYMEX
also offers a futures contract for Brent crude oil, trading in
this contract remains limited. The majority of futures
contracts for Brent crude oil are traded at the IPE in London.
---------------------------------------------------------------------------
\45\ Id. In addition to the trade in futures contracts, options to
buy or sell futures contracts are also traded on the NYMEX. Options
also are popular instruments used for hedging and speculating. For
simplicity, the following discussion refers only to futures.
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Exchange Membership and Clearinghouse
A commodity futures exchange like the NYMEX is similar to a
stock exchange in that it is an association of members who own
seats on the exchange and who can trade on the exchange. The
members of an exchange generally fall into several categories:
the commercial producers and purchasers of the commodities
traded on the exchange, speculators, and brokers. Members may
trade on the exchange for their own account or for others;
nonmembers must trade through brokerage firms.
A key feature of an exchange is a clearinghouse, which is
operated by or on behalf of the exchange. Generally, a number
of firms that are members of the exchange own and operate the
clearinghouse. In addition to keeping track of all the trades
that occur on the exchange each day, all trades must be cleared
through the clearinghouse, and the clearinghouse guarantees
performance on all the contracts traded on the exchange. When
two customers buy and sell futures contracts on an exchange,
each of their brokers actually conducts the transaction through
the clearinghouse rather than by bringing the customers
together. In effect, the clearinghouse acts as a party to every
transaction. Thus, when customers want to sell back or buy back
futures contracts, they do not need to find the original
counterparty; rather they need only find another party
interested in a new transaction, and the trade is again
conducted through the clearinghouse.
To guarantee contract performance, the members of the
clearinghouse deposit funds into the clearinghouse. The rules
of the exchange also require brokers trading through the
clearinghouse and their customers to post deposits or
``margins,'' related to the value of the positions taken in
their trades, to cover any losses that may occur. At the end of
each day of trading these margin accounts are ``marked-to-
market''--the exchange collects money from accounts that have
lost value and credits those accounts that have gained value--
so that sufficient funds to guarantee performance are on
deposit at all times. In this manner, ``counterparty risk''--
the risk that the other party to a trade will default on
performance--is virtually eliminated.
Traditionally, one of the major advantages of trading on an
approved exchange rather than over-the-counter has been that
the exchange guarantees financial performance and removes
counterparty risk, whereas in the over-the-counter market each
party to each contract assumes the risk that the other party
may fail to perform.\46\ According to the Chicago Board of
Trade, which uses a clearinghouse, ``the success of this system
is obvious. Since its start in 1925, no customer within or
outside of the [CBOT] exchange has lost money due to default on
a futures position.'' \47\
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\46\ But see infra, which explains that OTC traders can now trade
instruments backed by a clearinghouse.
\47\ Chicago Board of Trade, Action in the Marketplace.
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Regulation of IPE Brent Contracts
In the United Kingdom, the futures and over-the-
counter (OTC) markets are regulated by the Financial
Services Authority (FSA). Brent IPE contracts are
traded in a manner similar to the trading of NYMEX WTI
contracts, and many of the principles underlying the
U.K. system commodity market regulation are similar to
those of the U.S. system. There are also several
significant differences. The U.K. ``Code of Market
Conduct'' governing the U.K. futures exchanges and OTC
markets is less prescriptive than the regulatory system
under the CEA, emphasizing adherence to general
principles of conduct rather than detailed regulations.
Additionally, the U.K. ``light touch'' regulatory
system provides for less stringent regulation of
``professional'' markets, such as the IPE's crude oil
market, as opposed to markets in which retail investors
participate. The rationale for the light touch system
is that large institutions and market professionals are
sophisticated investors who have less need for
protective government oversight than small investors.
As explained in Appendix 2, U.S. law exempts certain
large market participants trading certain OTC
instruments from many CEA requirements, but applies the
full array of CEA requirements to the trading of crude
oil futures contracts on the NYMEX.
Market Oversight
The trading of futures contracts on the NYMEX and the other
approved commodities exchanges in the United States is
regulated by the Commodity Futures Trading Commission (CFTC)
under the Commodity Exchange Act (CEA).\48\ The goal of Federal
commodity market regulation is to ensure that the exchanges
remain ``a means for managing and assuming price risks,
discovering prices, or disseminating pricing information
through trading in liquid, fair and financially secure trading
facilities.'' \49\ The primary objectives of the CEA are ``to
deter and prevent price manipulation or any other disruptions
to market integrity; to ensure the financial integrity of all
transactions subject to this Act and the avoidance of systemic
risk; to protect all market participants from fraudulent or
other abusive sales or practices and misuses of customer
assets; and to promote responsible innovation and fair
competition among boards of trade, other markets and market
participants.'' \50\
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\48\ 7 U.S.C. Sec. 1 et seq.
\49\ Id., at Sec. 3. For more information on the regulation of
commodity markets, see Appendices 1 and 2.
\50\ Id.
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A cornerstone of the CEA is the system of self-regulation
by the exchanges. Although the CFTC is the Federal agency
responsible for regulating the futures markets, and has
authority to issue civil penalties for violations of its
regulations, and to refer potential criminal violations to the
Department of Justice for prosecution, \51\ the exchanges
themselves have the front-line responsibility for ensuring that
trading remains orderly, commodities brokers are properly
qualified and registered, sufficient margins are posted to
guarantee contract performance, and fraud or market
manipulation is detected and stopped. To be permitted to trade
futures, an exchange must establish rules and regulations for
trading, as well as market oversight and surveillance programs,
in accordance with the requirements of the CFTC under the CEA.
An exchange whose self-regulatory programs and futures
contracts have been approved by the CFTC is termed a
``designated contract market.'' Generally, a futures contract
for a commodity regulated under the CEA must be traded on a
designated contract market.\52\ A list of currently active
designated contract markets is provided in Table A.2-1 in
Appendix 2.
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\51\ Less than a handful of criminal prosecutions have been brought
for violation of the CEA. Markham, Manipulation of Commodity Futures
Prices--The Unprosecutable Crime, 8 Yale J. on Reg. 281, n.604 (1991).
\52\ The exceptions to this general rule are discussed infra.
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To ensure orderly trading, the exchanges have established
daily price limits for most commodity futures contracts
(limiting the amount the price can increase or decrease in 1
day); position limits for the clearing members of the exchange
(so that each clearing member has sufficient capital to cover
its commitments); position limits for customers with contracts
expiring in the current delivery month (to prevent squeezes of
the commodity in the final month of the contract); and
reporting requirements for customers with large positions in
the futures and options markets. The market oversight and
surveillance programs of each exchange monitor price movements,
trading practices, and the accumulation of large positions in
order to detect potential manipulations and squeezes and take
corrective measures before the market is disrupted.
Price Transparency
Each time a transaction is completed on the floor of an
approved exchange, the exchange records the pairing of buyers
and sellers and reports the transaction price. These prices are
available throughout the day from the exchanges via the
Internet, \53\ are published in specialty trade publications
and daily newspapers, and are reported on a weekly basis by the
Department of Energy's Energy Information Administration. The
timely availability of contract prices improves price
transparency--the ability of any market participant to see the
prevailing price level--and makes futures market contracts a
price reference for negotiations in the spot and term contract
markets.\54\
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\53\ See, for example, NYMEX website, at http://www.nymex.com.
\54\ DOE/EIA-0545(99), Petroleum: An Energy Profile: 1999, July
1999, 54-55; DOE, EIA, Oil Market Basics; GAO/FREC-93-17, 34-37; NYMEX
website, at http://www.nymex.com; and February 11, 2002, meeting with
NYMEX representative.
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Price Risk and Hedging
The most straightforward use of the futures market by a
crude oil producer or refiner is to ``hedge'' against adverse
price movements by locking in the prevailing price for future
deliveries. For example, an oil producer can establish a sales
price for oil that will be produced later by selling a futures
contract. Then, if a drop in market price causes the value of
the oil to decline, the decline in the value of the oil sold in
the physical market will be offset by the gain in the futures
market made when the futures contract is bought back later at a
lower price. Conversely, a refiner may want to fix the price
that must be paid for crude oil that will be needed in the
future. To do so, the refiner could purchase a futures contract
for delivery of oil at a specified date in the future. If the
price of crude oil increases in the cash market, the refiner's
increased costs in the physical market when the crude oil is
bought will be compensated for by its gain in the futures
market when at the same time the refiner sells back the futures
contract at a higher price. By limiting the uncertainty over
future costs, hedging allows companies to offer fixed price
arrangements to its customers for its products and to plan and
budget for the future without having to bear all of the risk of
price changes.\55\
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\55\ The term ``hedge'' means to take one position in one
transaction, such as selling a commodity, and the opposite position in
another transaction, such as purchasing the commodity, to minimize the
possibility of losses from one of the transactions. The word hedge
``evolved from the notion of the common garden hedge as a boundary or
limit . . .'' Roger Lowenstein, When Genius Failed (Random House,
1999), at 25.
---------------------------------------------------------------------------
In general, crude oil refiners are more concerned with
ensuring they receive adequate margins for their products
rather than absolute price levels. It does not necessarily
matter to a refiner whether crude oil is at $20 per barrel and
gasoline is selling at $23 per barrel, or crude oil is at $25
per barrel and gasoline is selling at $28 per barrel--the $3
per barrel margin is the same in both cases. What matters to a
refiner is the difference between the price of crude oil and
the price of refined products, such as gasoline. To protect
their margins, crude oil refiners will adopt trading strategies
that protect against changes in relative price levels rather
than lock in absolute price levels. These strategies typically
involve the simultaneous buying and selling of futures
contracts for different commodities, such as crude oil and
gasoline futures, or the simultaneous buying and selling of
futures contracts for the same commodity in different futures
months. These strategies, termed ``spread trading,'' can be
effective in locking in margins and protecting against
unanticipated changes in price.
Similarly, crude oil traders, like commodity traders in
general, are not so much concerned with absolute prices as they
are with relative prices. Whether crude oil is at $20 or $25
per barrel is not nearly as important to a trader as whether
crude oil was bought for less than it can be sold, or was sold
for more than it can be bought. Crude oil traders frequently
use spread trading to lock in the margin between buying and
selling.
Although exchange-traded futures contracts are standardized
with respect to the type and quantity of deliverable commodity,
standardized contracts can be used to hedge or speculate on
price movements for a much broader range of commodities when
there is a fairly predictable relationship between the
commodity being hedged and the commodity in the standardized
contract. Because the price of most crude oil is priced
relative to WTI or Brent, the futures markets for WTI and Brent
are used to hedge or speculate on price movements of many
varieties of crude oil. Thus, for example, a purchaser of crude
oil produced in Nigeria--which is priced at a differential to
Brent--could use the IPE Brent futures market to hedge against
movements in the price of Nigerian crude. Even with this hedge,
however, a producer or consumer of Nigerian crude oil would
continue to be exposed to the risk of a variance from the
normal differential between Nigerian crude and Brent. Such
variances could be caused by a variety of global or local
conditions, such as political events in Nigeria or the United
Kingdom, variations in commodity exchange rates, or changes in
the local supply and demand conditions affecting Brent or
Nigerian crude.
This latter type of risk is part of a price risk that
generally can never be completely hedged--namely, the variance
between the spot or cash price and the futures price of a
commodity. While the cash price of a commodity and the futures
price of the commodity generally converge at expiry of the
nearest-month contract, this convergence exists only for
delivery of standardized quantities at a particular location on
a particular date. Because most purchasers or sellers of
commodities would like their purchases and sales to occur
somewhere other than the specific location in the standardized
futures contract and at a time other than the particular date
on which a futures contract expires, the cash price for these
particularized transactions will differ from the standardized
futures price even at expiry. The risk that the cash price of a
commodity will differ from the futures price of that or another
commodity used for hedging purposes is known as ``basis risk,''
the ``basis'' being the difference between the cash price and
the futures price at a given location and time.\56\
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\56\ Typically, the local basis of a commodity will be determined
by transportation costs, storage costs, interest rates, and local
supply and demand conditions. To minimize risk, or to attempt to obtain
profits when cash and futures diverge from their historical
relationships, commodity producers, purchasers, and traders closely
follow the relationship between cash and futures prices and will
structure their trades accordingly. These patterns and relationships
are used to determine whether or not to accept cash bids for a
particular commodity; which buyer or seller to use; when to purchase,
store, or sell a particular commodity; when to terminate a hedge on the
futures market; and which future month of a commodity to use for
hedging or speculation. Chicago Board of Trade: Understanding Basis:
Improving Margins Using Basis (1998).
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Arbitrage
Although absolute price movements are impossible to
forecast accurately, it is possible to make predictions about
the relative prices of commodities in various markets, both
cash and futures. Many commodities have seasonal supply and
demand trends, and prices tend to follow corresponding seasonal
patterns. For example, although the absolute levels of future
gasoline prices are impossible to predict, gasoline prices in
the United States tend to be higher in the summer, when demand
is greatest. Traders use these patterns to minimize price risks
and costs.
In situations in which several different markets exist for
the same commodity, or similar commodities, different prices
may arise for the same or similar commodities, either in the
cash market or in the futures markets. Local supply and demand
conditions may influence one market more than another, traders
in different markets may have different information upon which
the market prices are based, or different traders may evaluate
the same information differently.
Different markets for the same or similar commodities are
linked together by the principle of ``arbitrage.'' ``The
general notion of cash arbitrage is that traders purchase goods
where they are cheapest and simultaneously sell them where they
are most expensive. In cash markets, arbitrage opportunities
occur when prices in the two markets differ by more than
transportation costs between the markets.'' \57\ In futures
markets, opportunities for arbitrage arise when traders believe
that futures prices for one commodity at a particular time in
the future depart from their historical relationship either to
the cash market, the futures prices for another commodity, or
the price of the same commodity at another time in the
future.\58\
---------------------------------------------------------------------------
\57\ Steven Errera and Stewart L. Brown, Trading Energy Futures &
Options, at 40 (1999).
\58\ Warren Buffet reportedly once said, ``Give a man a fish and
you feed him for a day. Teach him how to arbitrage and you feed him
forever.'' Kirk Kinnear, The Brent/WTI Arb (NYMEX website).
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Hence, although there are three major benchmarks and a
number of distinct, local markets for crude oil, these crude
oil benchmarks and markets, both cash and futures, are linked
together by the concept of arbitrage. Arbitrage trading between
the Brent markets and the WTI markets, to a large extent
determines the price and amount of oil imported into the United
States from the Atlantic basin. On average, Brent is less
expensive than WTI by about $1.50 per barrel, and it costs
between $1.00 and $1.50 per barrel to ship Brent across the
Atlantic in a large tanker. Because supply and demand
conditions in the European markets and the U.S. markets may
differ at any given time, the difference between the price of
Brent and the price of WTI can vary from this average. When the
price of Brent plus the cost of transporting Brent across the
Atlantic is less than the price of WTI, refiners will import
more Brent and Brent-priced crudes. When the price of Brent
plus the cost of transporting Brent across the Atlantic is more
than the price of WTI, refiners will import less Brent and
Brent-priced crudes, and instead rely more upon crude oil
produced in North and South America, as well as crude oil in
domestic inventories. The Brent-WTI price difference,
therefore, is one of the most significant factors determining
the price and volume of the transatlantic crude oil trade.
A significant amount of commodities and financial trading
today consists of sophisticated and complex arbitrage trading
designed to exploit differences between the various markets.
This type of arbitrage trading brings additional liquidity to
the market and helps bring the various markets into an overall
equilibrium.\59\
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\59\ The Long-Term Capital Management (LTCM) debacle demonstrates
how even sophisticated arbitrage trading carries risk. LTCM's strategy
was to exploit differences in currency exchange rates, bond prices,
interest rates, and other financial instruments, based on mathematical
models of the historical prices and volatilities of those instruments.
Although LTCM initially earned several billion dollars, with annual
returns greater than 40 percent, after Russia devalued the ruble and
defaulted on its bonds, an event not anticipated by the model, the fund
``blew up'' and spiraled into near-bankruptcy, ultimately requiring a
multi-billion dollar bail-out by the Wall Street firms and banks with
which it had large amounts of outstanding trades. See Inventing Money,
supra; When Genius Failed, supra.
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4. Over-the-Counter Markets
``Derivatives are financial instruments that have no
value of their own. That may sound weird, but it is the
secret of what they are all about.''
--LPeter L. Bernstein, Against the Gods (Wiley,
1998)
A derivative is any type of financial instrument that
derives its value from an underlying commodity or market index.
Strictly speaking, forward and futures contracts are types of
derivatives, since their value derives from the value of an
underlying commodity.
OTC trading instruments also derive their value from an
underlying commodity or market index but, unlike futures
contracts, are not traded on a regulated commodities exchange
and generally are not used by or offered to small businesses or
retail customers. Initially, OTC derivatives were developed as
customized devices to meet the particularized needs of parties
to protect themselves against adverse price movements in
financial and commodity markets, in situations in which such
risks could not be adequately addressed by the use of
standardized futures contracts on the regulated exchanges.
Until recently, the terms of most OTC instruments were
negotiated directly between the two parties to the transaction,
either face-to-face or through brokers over the telephone.
As OTC derivatives became more popular, parties to these
instruments became interested in trading these instruments to
help spread risks further. As a result, there has been a rapid
growth in the use of standardized OTC derivatives and in the
use of electronic exchanges to match parties seeking to trade
OTC derivative instruments.
Although the OTC market can provide the parties with more
flexibility in crafting particularized instruments than the
futures markets, the traditional OTC markets present a number
of additional risks as well. In the typical OTC transaction,
each party assumes the credit risk that the other party will
not perform. There is no ``OTC clearinghouse'' to guarantee
performance. In addition, unlike futures contracts, many
individually negotiated OTC instruments are not transferable to
third parties without the consent of both parties to the
original transaction. Additionally, there is less price
transparency in most of the OTC markets than on the designated
exchanges. There is also less government oversight to detect
and prevent market manipulation and fraud in the OTC markets
than on the designated exchanges.
Despite these drawbacks, the overall market for OTC
derivatives is now estimated to be several times larger than
the exchange-based futures markets. At the end of 1998, the
estimated total notional amount of outstanding OTC derivative
contracts was $80 trillion, whereas the estimated total value
of outstanding exchange-traded futures and options contracts
was $13.5 trillion.\60\ The vast majority of OTC derivatives
contracts are interest rate and foreign currency exchange
contracts; only a small fraction of the total relates to
tangible commodities such as crude oil. The OTC commodities
trade is nonetheless substantial; in 1999, the notional value
of OTC commodities contracts was estimated at approximately
$1.8 trillion.\61\
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\60\ Report of the President's Working Group on Financial Markets,
Over-the-Counter Derivatives Markets and the Commodity Exchange Act,
November 1999. The notional amount in a swap represents the value of
the commodity or index underlying the swap, not the actual value
swapped. Because there are no reporting requirements for OTC commodity
transactions, more specific data with respect to commodity derivatives
traded on the OTC markets is not available.
\61\ Information on Intercontinental Exchange (ICE) website, as of
October 2002.
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Normally, only large financial institutions, corporations,
or commodities firms participate in OTC markets. Many of these
traders, however, use both the OTC markets and the regulated
exchanges. Traders who trade on the designated exchanges often
prefer the advantages of a market with more participants and
trades (``liquidity''), the greater price transparency provided
by the exchanges, and the performance guarantees provided by
the exchange clearinghouses. Traders who participate in the OTC
markets may prefer the flexibility offered through
individualized transactions, have a greater capacity to assume
credit risks than other traders, and seek to avoid brokerage
fees and margin payments required on the exchanges. Some
traders may prefer the lesser degrees of transparency and
regulatory oversight.
OTC Swaps
A key type of OTC instrument used by oil and other
commodity traders is a derivative known as a ``swap.'' Swaps
were originally developed in the financial markets to hedge
against fluctuations in currency exchange rates, interest
rates, bond rates, and mortgage rates. Increasingly, they are
being used in commodity markets to hedge against fluctuations
in commodity prices. Like a futures contract, a commodity swap
locks in the value of a commodity at a particular price. For
example, in a swap for crude oil to be delivered in the future,
the seller will agree to pay the buyer for any increases in the
price of crude oil above an agreed-upon value between the time
the contract is entered and the time the crude oil is
delivered, while the buyer will agree to pay the seller for any
decreases below the agreed-upon value.
In both the commodities and financial markets, there are an
endless variety of swaps, individually tailored to address the
particular risk and speculative strategies of market players.
Definitive data regarding the magnitude of the swap market and
the type of instruments used is impossible to obtain, however,
since there is virtually no regulation of any swaps market.
One of the major advantages of the swaps market is that
swaps can be used to hedge against price changes for
commodities for which there is not a market on the designated
exchanges. To continue with a previous example, a crude oil
refiner intending to purchase Nigerian oil could use a swap to
hedge that part of the price risk that cannot be hedged by
purchasing a Brent futures contract. The refiner could purchase
a Brent futures contract to hedge that part of the price of the
Nigerian crude that is linked to the price of Brent, and then
enter into a swap with another party to hedge the risk that the
price of Nigerian crude may vary from the price of Brent crude
by a fixed differential. The ``price'' of this swap would be
the price of Brent on the IPE plus the fixed differential
between Brent and Nigerian crudes. Through this type of swap,
basis risks remaining after futures contracts are bought or
sold can be minimized.
Because swaps allow more precise risk management for
commodity traders they have become increasingly popular. Since
these commodity swaps are often linked to the value of a
commodity traded on a designated futures exchange, the growth
in the use of such swaps has contributed to a corresponding
growth in trading volume on the designated exchanges. In this
manner, the price discovery and hedging functions of the
designated exchanges and the OTC swaps market are now
intertwined.
Most swaps involving energy contracts, metals, and
financial instruments are excluded from the extensive
regulatory structure that the Commodity Exchange Act applies to
the trading of futures contracts.\62\ These statutorily
excluded swaps include any swap transaction involving a non-
agricultural commodity or financial instrument, between large
market participants, \63\ provided the transaction is
individually negotiated and not executed or traded on a
``trading facility,'' meaning an exchange-like facility where
multiple bids and offers are made and accepted. Under current
law, then, bilaterally negotiated swap agreements involving
crude oil are excluded from all regulation under the CEA.
---------------------------------------------------------------------------
\62\ Appendix 2 provides more detailed information on the
exclusions and exemptions for OTC energy contracts.
\63\ These large market participants, termed ``eligible contract
participants,'' include financial institutions, brokers and dealers,
corporations with more than $5 million in assets, and individuals with
more than $10 million in assets. 7 U.S.C. Sec. 2(g) (West Supp. 2002).
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Example of a Crude Oil Swap
In April a refiner is planning its crude oil
purchases for December. The NYMEX price for December
delivery of WTI is $25 per barrel, and December
gasoline futures are at $30 per barrel. The refiner
wants to lock in this $5 margin for 10,000 barrels. A
Wall Street investment firm believes that over the same
period the Euro will weaken relative to the dollar,
making European crudes cheaper for U.S. refiners to
import, and therefore WTI will fall in price. Neither
firm is concerned about non-performance by the other,
since they both have significant assets. In the swap,
they agree that in December, if the NYMEX price for
December delivery has increased above $25, the Wall
Street firm will pay the refiner the difference, and if
the price has decreased, the refiner will pay the Wall
Street firm the difference. Thus, if the December price
rises to $26, the Wall Street firm will pay the refiner
$10,000 (10,000 barrels at $1 per barrel). The
refiner's net cost for crude oil in December is still
$25 per barrel ($26 per barrel market price minus $1
per barrel payment from the Wall Street firm). If the
December price falls to $24, the refiner will pay the
Wall Street firm $10,000, yet its net cost for the
crude still will be $25 per barrel ($24 market price
plus $1 payment to the Wall Street firm).
Although the swap is a hedge for the refiner, it is
speculation for the Wall Street firm, since the firm
will profit if the price of WTI falls as it projects,
but lose if the market moves in the other direction.
Should the Wall Street firm decide it no longer wishes
to speculate on the price of December crude oil, it
could buy a NYMEX December futures contract for WTI, in
which case it, too, would be hedging. Although the
notional value of this swap is $250,000 (10 barrels x
$25/barrel), the actual payments will be much less.
OTC Electronic Exchanges
Although OTC market participants desire flexibility to
craft instruments to address their particular risk strategies,
they also would like to be able to trade these instruments when
market conditions change. Thus, although there is a large
amount of innovation and customization in the types of
instruments that are traded on the OTC markets, there also is a
movement towards the standardization of features to facilitate
the trading of these instruments.
Recently, a number of companies have created organizations
and facilities to take advantage of the growing desire to trade
in OTC instruments. Generally, they have used strategies that
fall into two broad categories. The first, typified by ``Enron
Online,'' provides an OTC trading facility in which the company
hosting the facility acts as the counterparty to all of the
other parties seeking to buy or sell instruments. These are
termed ``one-to-many'' facilities because one party acts as the
counterparty to many other parties. The Enron scandal has
exposed a number of weaknesses in this business model, as it
provides the one counterparty with significant market power and
knowledge that can be used to manipulate the market at the
expense of all of the other traders.
The second approach, which has become the most successful
type of OTC trading facility, is the ``multilateral
transactional facility,'' whereby an organization provides an
electronic trading ``platform'' that facilitates OTC trading
between the parties using the platform, but does not provide
clearinghouse operations to guarantee performance or monitor
trades.
Using this second approach, in 2000, several investment
banks and oil companies formed the Intercontinental Exchange
(``ICE'') to trade in OTC energy and metals derivatives.\64\
Located in Atlanta, Georgia, the ICE is an electronic exchange
open only to large commercial traders.\65\ Rather than provide
a counterparty to all trades, as do the NYMEX and IPE
clearinghouses, ICE acts only as a posting facility for bids
and offers, which the traders can then choose to accept or
reject.\66\ Any large commercial company can trade on ICE's
facility without having to employ a broker or pay a fee to a
member of the Exchange. All trades are bilateral deals between
the buyers and sellers. There is no clearinghouse and,
accordingly, no requirement to post margins. The ICE website
advertises: ``There are no memberships. No artificial
restrictions. No dues or fees beyond those incurred in the
trading itself.''
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\64\ The founding partners of ICE are BP Amoco, Deutsche Bank AG,
Goldman Sachs, Dean Witter, Royal Dutch/Shell Group, SG Investment
Bank, and Totalfina Elf Group.
\65\ Participation is restricted to parties that quality as an
``eligible commercial entity'' under Sec. 1a(11) of the CEA. Generally,
the entities that qualify are large financial institutions, insurance
companies, investment companies, corporations and individuals with
significant assets, employee benefit plans, government agencies, and
registered securities brokers and futures commission merchants.
\66\ To the extent that all bids, offers, and contract prices of
traders using ICE are posted on the ICE system, ICE provides a degree
of price transparency that is wholly absent in other OTC transactions.
---------------------------------------------------------------------------
Although ICE does not require exchange memberships or
operate its own clearinghouse, it has established an
alternative system for traders to protect against counterparty
credit risk. ICE has arranged for traders using the ICE trading
platform to apply to the London Clearing House or the Chicago
Board of Trade Clearing Corporation for performance guarantees.
The ICE software identifies traders who have obtained such
performance guarantees, so that traders can choose to accept
bids and offers from only those other traders who have obtained
such guarantees. A party trading on the ICE platform can
eliminate counterparty risk just as if he or she were trading
on a futures exchange, thereby eliminating one of the major
disadvantages of OTC trading.
The ICE describes the benefits of using its OTC clearing
system as follows: ``OTC Clearing on the Intercontinental
Exchange provides traders and risk managers the best of both
worlds: the safety and security offered by a central
clearinghouse along with the flexibility and accessibility of
the fully-electronic ICE platform.'' \67\
---------------------------------------------------------------------------
\67\ ICE, Clearing and Credit, at http://www.theice.com/risk.html.
---------------------------------------------------------------------------
A 2001 ICE press release describes the extent of the ICE
system:
[ICE's electronic trading system] is installed on over
6,500 desktops worldwide from which traders log on each
day of the business week to trade more than 600 listed
commodity and derivative contract types, approximately
200 more than when Intercontinental went live. Broadly,
these include crude oil and refined products, natural
gas, power, precious metals, and emissions allowances.
Contract forms include physical delivery as well as
financially settled swaps, spreads, differentials and
options based on a variety of fixed and floating price
indices.
According to this release, the total notional value of the
contracts traded on IPE over the previous 12 months was in
excess of $500 billion. As of 2001, the daily volume of oil
traded on the ICE was approximately 19 million barrels.\68\
---------------------------------------------------------------------------
\68\ Information obtained from ICE website, http://www.theice.com/
home.html.
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The NYMEX also operates an electronic trading platform for
the trading of standardized OTC instruments. The NYMEX OTC
platform opens for the trading for crude oil contracts at 3:15
p.m., 45 minutes after the close of the open outcry trading in
the NYMEX pits, and then closes at 9 a.m. the next morning, 1
hour before exchange trading begins again.
NYMEX also recently began to provide clearinghouse services
for traders using the NYMEX electronic trading platform. NYMEX
describes its system as follows:
NYMEX ClearPortsm clearing services are
also available to market participants who wish to
conduct bilateral energy transactions in a slate of 23
standardized contracts for crude oil, natural gas
basis, refined products, and electricity and submit
them for clearing. Cleared bilateral transactions are
submitted, margin requirements are calculated, and the
transactions are processed by the clearinghouse in the
same manner as the NYMEX Division futures
contracts.\69\
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\69\ NYMEX ClearPortsm Services Overview, at http://
209.67.30.245/jsp/markets/cp--overvi.jsp.
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5. Convergence of Futures and OTC Markets
As OTC instruments have become standardized, and
organizations that operate the designated futures exchanges,
like the NYMEX and the ICE/IPE, offer OTC instruments for large
institutional traders and provide clearing services for OTC
trades, the traditional distinctions between these OTC markets
and the futures markets have vanished. Both the futures
exchanges and the OTC electronic trading platforms offer
standardized instruments; both offer ways to eliminate
counterparty risk; and traders purchase, sell, and trade
derivative instruments on both markets to hedge price risk. The
NYMEX description of its clearing services for OTC trades
states: ``Energy market participants no longer have to choose
between the safety of the cleared, standardized markets of the
Exchange, and the exposure to counterparty default that has
traditionally been the drawback to customized deals in the
over-the-counter markets.'' \70\
---------------------------------------------------------------------------
\70\ NYMEX ClearPortsm Clearing Overview, About NYMEX at
ClearPortsm Clearing http://209.67.30.245/jsp/markets/otc--
overvi.jsp.
---------------------------------------------------------------------------
The OTC markets and the regulated exchanges now offer
identical instruments for trading. The NYMEX, for example, now
offers futures contracts for OTC trading. Specifically, as
shown in Exhibit III-1, one can trade instruments NYMEX calls
``Light Louisiana Sweet Crude Oil Futures'' and ``West Texas
Sour Crude Oil Futures'' on the NYMEX OTC trading platform.\71\
These futures contracts traded electronically on the NYMEX OTC
platform are identical in form and function to the futures
contracts traded on the NYMEX pit. On the ICE, the instruments
that are traded are so similar to futures contracts they are
called ``futures look-alikes.'' Crude oil traders interviewed
by the Subcommittee staff stated that, from their perspective,
there was no functional difference between the types of crude
oil derivatives they traded on the OTC electronic platforms and
on the NYMEX or the IPE.
---------------------------------------------------------------------------
\71\ See NYMEX website, at http://www.nymex.com/jsp/markets/lsco--
otc--llspe.jsp (LLS OTC futures); http://www.nymex.com/jsp/markets/
lsco--otc--wtsspe.jsp (West Texas Sour OTC futures). NYMEX also
provides for OTC trading of WTI contracts with future delivery in
Midland, Texas, and for trading of Mars Blend Crude Oil with delivery
in the Gulf of Mexico. Although these contracts appear to be identical
to futures contracts, they are not labeled as such on the NYMEX
website.
---------------------------------------------------------------------------
The OTC markets for crude oil were further intertwined with
traditional futures markets for crude oil when, in 2001, ICE
acquired the London IPE. Following the acquisition, ICE moved
to integrate its OTC trading of Brent-related derivatives with
the trading of Brent contracts on the London IPE. Recently, ICE
began to offer a particular type of Brent contract, the ``BFO
contract,'' for trading on ICE's platform.\72\ Previously,
these Brent OTC instruments had been traded exclusively through
OTC brokers. To further mesh the operations of ICE and the IPE,
the London IPE plans to do away with open outcry trading of
Brent futures and move towards an all-electronic trading
system.
---------------------------------------------------------------------------
\72\ The BFO contract is explained in the following subsection.
---------------------------------------------------------------------------
6. Disparity in Market Disclosure and Oversight
The U.S. futures markets, such as the NYMEX, are the most
heavily regulated and transparent commodity markets in the
world. Commodity trading on these markets is subject to a
variety of reporting requirements and regulations designed to
detect and deter fraud and manipulation. This regulation and
transparency has bolstered the confidence of traders in the
integrity of these markets and helped propel the United States
into the leading marketplace for many of the commodities traded
on these exchanges.
Today, there are few, if any, differences between the
commodity derivative instruments traded on the regulated
futures markets and on OTC markets. Although many of the
distinctions between the OTC and futures markets have
disappeared in recent years, the trading of derivative
instruments on OTC markets is subject to much less regulation
than the trading of equivalent instruments on the regulated
futures exchanges. For example, unlike the regulated exchanges,
OTC trading facilities are not required to monitor trading to
detect and deter fraud and manipulation. Commodity prices do
not have to be disclosed to any oversight body. Although the
new electronic trading facilities operated by NYMEX and ICE are
improving the price transparency of the OTC market by making
data on posted bids, offers, and completed trades available,
other trading information routinely reported to the futures
exchanges and the CFTC is not available. Large trader reports
do not have to be provided on a routine basis to the CFTC, and,
unlike trading on the NYMEX, there are no position limits or
daily price limits.\73\
---------------------------------------------------------------------------
\73\ See Appendix 2.
---------------------------------------------------------------------------
A common justification for this disparity in treatment is
that the large institutions using OTC markets are sophisticated
traders with less need for governmental protection from
misconduct. Largely for this reason, Congress determined it was
not necessary to apply most of the regulatory safeguards of the
CEA to OTC markets in which smaller investors and members of
the public do not participate.
With the convergence of the OTC and futures markets,
however, this rationale is no longer convincing. Price
manipulation in one market can harm other markets involving the
same commodity, negatively affect related commodities, and
ultimately harm a broad range of the American public. Federal
regulation of the commodity markets is designed to protect not
just small commodity traders, but also the purchasers of those
commodities and the public at large. In the CEA, Congress
clearly articulates the national interest in preventing market
manipulation:
The transactions and prices of commodities on such
boards of trades are susceptible to excessive
speculation and can be manipulated, controlled,
cornered or squeezed to the detriment of the producer
or the consumer and the persons handling commodities
and the products and byproducts thereof in interstate
commerce, rendering regulation imperative for the
protection of such commerce and the national public
interest therein.\74\
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\74\ 7 U.S.C.A. Sec. 5 (West 1999).
The history of commodity markets demonstrates it is
unrealistic to rely on the self-interest of a few large traders
to protect the integrity of an entire market.\75\ The self-
interest of a limited group of large traders is not synonymous
with the public interest, and it is not the responsibility of
individual traders to look out for public rather than private
interests. Most recently, the Enron scandal, which led to
exposure of misconduct by traders at several large energy
companies active in OTC trading, provides new evidence of how
the conduct of a few sophisticated traders can harm not only
other market participants, but also the public at large by
artificially increasing prices.\76\ Consumers paying
artificially elevated prices suffer the same harm regardless of
whether the commodity price was manipulated through trades
executed on regulated exchanges, on OTC electronic trading
platforms, or through false information about prices and trades
conveyed to price reporting services.
---------------------------------------------------------------------------
\75\ See discussion of commodity market regulation in the
Appendices to this Report.
\76\ See, e.g., August 2002 report prepared by the Federal Energy
Regulatory Commission (FERC) staff, Docket No. PA02-2-000, which found
significant evidence of price manipulation and deceptive practices by
Enron in connection with its OTC electronic trading platform known as
Enron OnLine. The report includes a detailed analysis of natural gas
trades made on Enron OnLine for next-day delivery into California over
the course of a single day, January 31, 2001. The report found that of
a total of 227 trades on that day, 174 involved Enron and a single
unnamed party; these 174 trades took place primarily during the last
hour of trading; and by utilizing ``higher prices,'' these trades
resulted in a steep price increase over the last hour of trading. The
report also noted that price information displayed electronically on
Enron OnLine was a ``significant, even dominant, source'' of price
information used by reporting firms publishing natural gas pricing
data. The report tentatively concluded that Enron OnLine price data was
susceptible to price manipulation and may have affected not only Enron
trades, but also increased natural gas prices industrywide. See also,
e.g., ``FERC Asks Gas Marketers for Data Given to Indexes,'' Wall
Street Journal, October 29, 2002 (``A handful of companies have already
disclosed in recent weeks that their traders provided inaccurate
information to publishers of natural-gas indexes.--If traders provided
false information--such as pricing and volumes--the possibility exists
that they may have manipulated large swaths of the country's gas
markets.''); Plea Agreement filed by former Enron trader Timothy
Belden, United States v. Belden (USDC NDCA, Case No. CR 02-0313 MJJ),
October 17, 2002, admitting to conspiracy to commit fraud ``to obtain
increased revenue for Enron from wholesale electricity customers and
other market participants in the State of California'' and to
``manipulat[ing] prices'' in certain energy markets. Although these
instances of fraud and manipulation did not occur through the use of
many-to-many electronic trading facilities, they nonetheless illustrate
the impact that misconduct by OTC market participants can have on the
general public.
---------------------------------------------------------------------------
The record also demonstrates that a legal prohibition
against commodity market manipulation, without routine market
disclosure and oversight, does not effectively deter or prevent
manipulation.\77\ Routine market disclosure and oversight are
essential to halt manipulation before economic damage is
inflicted upon the market and the public. As one former CFTC
Chairman stated: ``The job of preventing price distortion is
performed today by regulatory and self-regulatory rules
operating before the fact and by threats of private lawsuits
and disciplinary proceedings after the fact. Both elements are
essential.'' \78\
---------------------------------------------------------------------------
\77\ See extensive analysis in Appendix 1.
\78\ In re Indiana Farm Bureau Cooperative, 1982 CFTC LEXIS 25, 72
(Stone, dissenting), Comm. Fut. L. Rep. (CCH) para. 21,796 ['82-'84
Transfer Binder] (CFTC Dec. 17, 1982).
---------------------------------------------------------------------------
The manipulation of the copper markets in the 1990's by
Sumitomo Corporation demonstrated that, given a choice, some
traders will operate on less-regulated, less-transparent
markets in order to avoid the routine disclosure and oversight
that takes place on the U.S. futures exchanges.\79\ Sumitomo
traders admitted using less-regulated overseas and OTC markets
to avoid detection by U.S. regulatory authorities. Hence, a
disparity in the degree of oversight of different markets that
provide traders with functionally equivalent instruments for
trading undermines the oversight mechanisms of the more
regulated market.
---------------------------------------------------------------------------
\79\ See Appendix 1 for a discussion of the Sumitomo case.
---------------------------------------------------------------------------
The Subcommittee Minority staff's findings indicate that
the current disparity in market disclosure and oversight
afforded OTC crude oil markets compared to the regulated
exchanges is not justified. OTC markets today function as major
trading centers for crude oil derivatives. OTC markets
regularly affect crude oil prices on the regulated exchanges,
and vice versa, since many of the same traders use both the OTC
and futures markets for risk-spreading and price discovery, and
trade virtually identical instruments in both markets. The
price of many OTC derivatives are linked directly to futures
prices on the regulated exchanges.
The unavailability of OTC trading data was a major obstacle
to the Subcommittee Minority staff's investigation of
allegations of manipulation of crude oil markets in 2002. The
absence of data regarding OTC prices and trades made it
impossible to determine the extent to which traders may have
sought to exploit or exacerbate squeezes through activity on
OTC markets. The absence of OTC information made it impossible,
in practice, to get a complete picture of crude oil market
behavior to determine whether manipulation took place.
Since many of the instruments traded on the regulated
exchanges and OTC markets are virtually identical, traders
often operate in both settings, and both markets handle
billions of dollars in commodity transactions daily, it makes
little sense to apply the full panoply of reporting
requirements and market oversight to one market but none to the
other. The absence of small traders in the OTC markets does not
make the market less susceptible to price manipulation. Indeed,
a market with fewer, larger participants may be even more
susceptible to price manipulation. Moreover, due to the
increasing interaction between the OTC and futures markets,
price manipulation in one market necessarily affects prices in
the other market.
The following discussion of the Brent crude oil market
illustrates these points. It explains the interconnections
among the spot, futures, and OTC markets for Brent, and how the
price of Brent in one type of crude oil market can affect the
price of Brent in another. It also describes the relationship
between the prices of Brent and WTI, which normally rise and
fall together in response to global factors affecting crude oil
supply and demand. Using the example of the 2000 Arcadia
squeeze, the analysis shows how a market squeeze in Brent can
disrupt the normal relationship between Brent and WTI, and
increase the price of Brent relative to WTI. This explanation
of the Brent market provides a broader context for
understanding the following Section of this Report, Section IV,
which shows how depositing large amounts of Brent into the SPR
not only spiked the price of Brent in world markets, but led to
a cascading set of price spikes in other crude oil and
petroleum products in the United States.
B. Crude Oil Price Benchmarks
This part of Section III provides more information about
the three types of crude oil, Brent, WTI, and Dubai, that
function as price benchmarks for crude oils traded around the
world. Additional information is provided about the Brent
market for the light it sheds on how crude oil spot, futures,
and OTC markets interact, how Brent and WTI markets relate to
each other, and how a market manipulation spikes crude oil
prices and can shift the price curve for near-term and long-
term crude oil contracts.
1. Brent Crude Oil
``A major feature of the Brent market is that it
works extremely well as long as one does not think
about it too hard.''
--LPaul Horsnell, Oxford Institute for Energy
Studies Monthly Comment, May 2000
Brent is a light, sweet crude oil produced in the North Sea
within the territorial waters of the United Kingdom.\80\
Because Brent is slightly heavier and has slightly more sulfur
than WTI, which is also a light, sweet crude oil, it normally
costs less than WTI.
---------------------------------------------------------------------------
\80\ Brent crude oil is a mixture of the oil produced in 19
separate oil fields in the North Sea. The oil is collected through two
distinct pipeline systems (the Brent and Ninian systems) to a loading
terminal at Sullom Voe in the Shetland Islands. Paul Horsnell and
Robert Mabro, Oil Markets and Prices 11 (Oxford University Press,
2000). The Sullom Voe terminal is operated by the Royal Dutch/Shell
Petroleum oil company.
---------------------------------------------------------------------------
More crude oil is priced in relation to Brent than to any
other type of crude oil. Brent serves as the benchmark for
approximately 40-50 million barrels of crude oil produced
daily. Most of the crude oil priced off Brent is purchased in
Europe. About one-fifth of the 10 million barrels of crude oil
imported daily into the United States are priced off Brent. As
Figure III-3 shows, the Brent-based imports come from west
Africa and northwest Europe.
[GRAPHIC] [TIFF OMITTED] T5551.150
The U.K. oil fields, including the Brent fields, are among
the most mature of the oil fields in the North Sea, and the
production of Brent is in decline. In the early 1990's, the
Brent fields produced approximately 700,000 barrels per day,
which is the equivalent of about 60 cargoes per month. By 2002,
production had fallen to around 350,000 barrels per day, or
about 20-25 cargoes per month. Production is expected to
decline by approximately 15 percent per year for the next
several years. (Figure III-4).
[GRAPHIC] [TIFF OMITTED] T5551.017
As is explained in more detail in Section III.C., the drop
in the number of Brent cargoes leaving the Sullom Voe terminal
to less than 1 per day made the Brent market much more prone to
distortions and squeezes. To alleviate this problem, in July
2002, Platts added two other grades of North Sea crude oil,
Forties and Oseberg, to the pool of oil from which it computes
the price of ``Brent.'' \81\ In September, the London IPE
approved the inclusion of Forties and Oseberg within the Brent
benchmark. The new benchmark is still often referred to as
Brent, but also is called ``BFO.'' The inclusion of the Forties
and Oseberg grades within the Brent benchmark has increased the
number of cargoes to about 60 cargoes per month and reduced the
vulnerability of the Brent benchmark price to manipulation.
---------------------------------------------------------------------------
\81\ See footnote 55 for a description of how the price of Brent is
calculated.
---------------------------------------------------------------------------
The market for Brent is actually a complicated
interrelation of four sub-markets: (1) an OTC market for ``15-
day Brent'' which, in 2002, changed to an OTC market for ``21-
day Brent''; \82\ (2) the spot market for ``dated Brent''; (3)
the Brent futures market; and (4) an OTC market for Brent-based
derivatives.\83\ Table III-1 summarizes the purpose and
function of the four Brent sub-markets. Oil companies and
traders use the 21-day Brent market to purchase standardized
contracts for the delivery of 600,000 barrel Brent cargoes up
to 21 days prior to the loading of those cargoes at the North
Sea terminal. The dated Brent market is the spot market used to
buy or sell Brent cargoes once they are about to be or after
they already have been loaded on ship. The futures market and
OTC swaps are used for hedging and speculation, but rarely to
obtain actual delivery of oil.
---------------------------------------------------------------------------
\82\ The 21-day BFO contract replaced the 15-day Brent contract
when the Forties and Oseberg grades were added to the benchmark. The
additional 6 days were provide to allow buyers more time to make
arrangements for delivery if Forties or Oseberg were delivered rather
than Brent.
\83\ See Crude Oil Handbook, supra, at B9-B17.
[GRAPHIC] [TIFF OMITTED] T5551.005
Only part of one of these Brent markets--the futures
market--is regulated in the United States. Although Brent
contracts traded on the NYMEX are fully regulated under the
CEA, the vast majority of Brent futures trading takes place on
the London IPE, which is regulated by the U.K. Financial
Services Authority.\84\ The Brent OTC markets, including the
swaps and 15/21-day Brent contracts, have been exempted from
most regulations by the CFTC and the Congress. The result is
that the bulk of the Brent market is not regulated under U.S.
law.
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\84\ See Section III.A.
---------------------------------------------------------------------------
The complexity of the Brent market has evolved largely for
historical reasons, as each type of contract or financial
instrument was designed to fill a market need at a particular
time. As one commenter has written: ``Physics may say that the
bumblebee can not fly, but the bumble bee does not think about
it. Financial theory would not produce a design like Brent, but
Brent traders should also not think about it. The market has in
general evolved more through chance than design.'' \85\ The
following subsections provide additional detail about the Brent
market.
---------------------------------------------------------------------------
\85\ Paul Horsnell, Oil Pricing Systems, Oxford Institute for
Energy Studies, Monthly Comment, May 2000 (a version of this article
originally appeared in Pipeline, the magazine of the IPE). A thorough
explanation of the Brent market is found in Horsnell and Mabro, Oil
Markets and Prices, supra.
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a. 15- and 21-Day Brent
The 15-day Brent market evolved to address the need of
producers, traders, and purchasers of Brent crude oil to be
able to trade in a contract that could accommodate the
peculiarities of the Brent production schedule. The major
owners of the crude oil in the Brent fields--Shell, BP, Exxon,
and Philips/Conoco, which are called the ``equity producers''--
all use the terminal at Sullom Voe, in the Shetland Islands,
off the coast of Scotland, to load the Brent crude oil onto
crude oil tankers, some of which can hold up to 2 million
barrels of oil. One company, Royal Dutch/Shell, the operator of
the Sullom Voe terminal, controls the monthly production and
delivery schedule. Shell requires each company that desires to
load one or more cargoes at the terminal in any given month
nominate the cargoes for loading by the 5th day of the
preceding month. Shell finalizes the entire monthly loading
schedule by the 15th day of the preceding month.
Until Shell finalizes the loading schedule on the 15th of
each month, the producers of Brent crude oil do not know when
their crude oil will be available for delivery or sale on the
spot market. Initially there can be as much as 30 days
variability as to when a particular cargo will actually be
delivered. Accordingly, contracts for 15-day Brent specified
the month, anywhere from 1 to 4 months in the future, but not
the particular date, in which the cargo of Brent will be
loaded. Under the 15-day contract, the seller of a cargo to be
delivered in a future month was required to provide at least 15
days advance notice to the purchaser of when the cargo will be
loaded at the Sullom Voe terminal. Now, under the 21-day
contract, the seller is required to provide at least 21 days
advance notice.
Even though a producer may know anywhere up to 6 weeks in
advance of when a particular cargo will be loaded, the
purchaser of that cargo may not learn of the loading date until
21 days in advance. Depending upon the market conditions at the
time the notice is provided and the purchaser's commercial
objectives, the purchaser may or may not want actual possession
of the cargo. If the original purchaser has sold another 21-day
contract to a second buyer, the first purchaser can require the
second buyer to take the cargo if at least 21-days notice is
given to the second buyer. The second buyer, in turn, may have
sold a 21-day contract to a third buyer, and so on. In this
manner, 21-day Brent can move through a ``daisy-chain'' of
buyers and sellers until a purchaser desires physical
possession of the oil or the 21-day notice period expires and
timely notice cannot be provided to any more buyers.\86\
---------------------------------------------------------------------------
\86\ Under the 15-day contract, the 15-day notice period expired at
5 p.m., Greenwich Mean Time, 15 days before the 3-day loading period or
``window.'' A holder of a contract who received notice at the last
possible moment before the expiration of the notice period and was
unable to require another purchaser to take delivery was said to have
been ``five o'clocked'' or just plain ``clocked.''
---------------------------------------------------------------------------
Purchasers of 21-day Brent can also opt out of the contract
by identifying other contract holders with opposite positions
and settling out their obligations with each other, along with
any necessary adjustments for differences in transaction prices
(called ``offset'' or ``bookout''). As with a typical futures
contract, there may be many more 21-day contracts for the
loadings of Brent in any particular month than there are actual
cargoes of Brent in that month.
The market for 15- and 21-day Brent always has been limited
to major oil companies and traders. The large size of each
contract--each 15-day contract represented a cargo of 500,000
barrels, and each 21-day contract represents a cargo of 600,000
barrels--the complicated mechanics of the daisy chain, and the
informal nature of the market are major impediments to small
traders. In the 1980's, about 100 companies traded in this
market. As the formal futures markets became more established
(the 15-day market existed prior to the futures market for
Brent), and trading in over-the-counter derivatives increased,
the market for 15-day Brent contracted. By the late 1990's,
only about 30 traders remained. By 1998, the 10 most active
traders accounted for over 80 percent of the deals with
identified buyers and sellers.\87\
---------------------------------------------------------------------------
\87\ Crude Oil Handbook, at B12. The 15-day market also developed
to enable Brent producers to ``tax spin'' to reduce their tax liability
to the British government. Under the British tax code in effect at the
time this market developed, the tax paid by producers of North Sea
crude oil was based on the market price of the crude oil, which was
calculated on the basis of the prior transactions for that type of oil.
Under tax spinning, ``an oil company would sell a contract to deliver
oil into the market. This contract would pass through many hands and
frequently end up back with the original company, completing what the
market called a daisy chain. Positions would be cancelled out, losses
and gains paid up, and the oil company was able to pay taxes based on
the lowest price paid for an individual cargo while it shipped the oil
off to its refinery.'' Steven Butler, Nervous Trading in a Market Held
in Limbo, Financial Times (London), May 3, 1990; see also Transnor v.
BP, 738 F.Supp. 1472 (S.D.N.Y. 1990).
---------------------------------------------------------------------------
Traditionally, 15-day Brent contracts have been bought and
sold through OTC brokers. In September 2002, ICE began to post
bids and offers for 21-day BFO contracts on its electronic
trading platform.
As explained in Appendix 2, the nature and status of 15-day
Brent contracts under U.S. commodities law was debated
throughout the 1990's. The U.S. District Court for the Southern
District of New York ignited this controversy in 1990 when, in
the case Transnor v. BP, the court held that: the 15-day Brent
market had a substantial effect on interstate commerce in the
United States; the 15-day Brent market was subject to the
jurisdiction of the U.S. courts and the CFTC; and 15-day Brent
contracts were futures contracts within the meaning of the
Commodities Exchange Act. The British government, Wall Street
trading firms, and U.S. oil companies charged that the district
court's decision was an unjustified extension of American
jurisdiction into a British market, could undermine much of the
Brent market, and cast doubt on the validity of a host of OTC
contracts. In response, the CFTC issued a ``statutory
interpretation'' that 15-day Brent contracts were not futures
contracts subject to the CEA, but rather were forward contracts
excluded from CEA regulation.
In the Futures Trading Practices Act of 1992, Congress
ratified the CFTC's authority to exempt 15-day Brent and other
contracts that could be considered futures contracts from CEA
requirements. In 1993, the CFTC issued implementing regulations
exempting a host of energy derivatives traded between large
institutions, including 15-day Brent contracts, from most of
the CEA requirements. Under the Commodity Futures Modernization
Act of 2000, a variety of energy derivatives, including 21-day
Brent contracts bought and sold on the ICE, are exempted from
many of the CEA's requirements. The end result is that the 21-
day Brent market is subject to very limited oversight by U.S.
authorities.
b. Brent Spot Market: ``Dated Brent''
Brent crude oil bought and sold on the spot market is known
as ``dated Brent.'' Once the notice period has expired under
the 21-day Brent contracts, and the daisy chain has ended, the
Brent oil that is to be loaded in the specified time period is
traded on the spot market as dated Brent. Dated Brent is
generally traded within 21 days of the loading date.
The largest sellers of dated Brent are the Wall Street
financial institutions and crude oil traders who have purchased
Brent on the forward or futures market, and the largest buyers
of dated Brent are the oil companies with refineries in
Northwest Europe and in the northeastern United States.
As dated Brent refers to crude oil that is to be loaded in
the immediate future, it is the price of dated Brent that is
used as the benchmark price for spot and contract transactions.
The current price of dated Brent transactions is reported daily
by reporting services such as Platts and Petroleum Argus.
As a cash commodity market, the market for dated Brent has
never been regulated, either in the United States or Britain.
Although the CFTC may have the legal authority under a strict
reading of the CEA to prevent fraud and manipulation in the
spot or ``cash'' market for a commodity regulated under the
CEA, the CFTC has never attempted to exercise authority over
any spot market apart from its oversight of the corresponding
futures market for that commodity. For all practical purposes,
the dated Brent market is unregulated.
c. Brent Futures Markets
Although the NYMEX offers trading in a Brent futures
contract, most Brent futures contracts are traded on London's
IPE. Unlike the NYMEX WTI contract, which requires delivery of
the physical commodity upon expiry, both the NYMEX and the IPE
futures contracts for Brent are cash-settled. Upon expiry, the
holders of outstanding contracts requiring delivery must pay
the exchange the value of the Brent oil to be delivered, and
the holders of the outstanding contracts requiring acceptance
of delivery are paid the value of the crude oil to be
delivered. No physical delivery of Brent oil is required.
Because the 21-day Brent contract has many characteristics
of a futures contract and the 21-day market performs many of
the same functions as a futures market, the IPE Brent futures
market is structured to converge to the 21-day market at
expiry. The value of the Brent crude oil in the futures market
on the date of expiry is therefore linked to the price of the
next shipment of Brent crude oil in the 21-day market on that
date.\88\ By providing a price discovery mechanism for traders
in the 21-day market, the IPE Brent futures market makes the
more limited 21-day market less susceptible to manipulation.
---------------------------------------------------------------------------
\88\ This settlement price, termed the ``Brent index,'' is computed
by taking the average of the following three elements: (1) the price of
first month trades in the 21-day market; (2) the price of second-month
trades in the 21-day market plus or minus a straight average of the
spread trades between the first and second months; and (3) a straight
average of all the price assessments published in media reports. These
three elements are averaged to minimize the ability to manipulate the
IPE price through the manipulation of the off-exchange prices used to
calculate the Index. IPE, IPE Brent Crude Futures Contract, available
at http://www.ipe.uk.com/include/downloads/contracts/bc--futures.pdf.
---------------------------------------------------------------------------
The IPE Brent futures market attracts a much broader range
of participants than the 21-day market, largely as a result of
the smaller size of the standard contract--1,000 barrels for an
IPE contract as opposed to 600,000 barrels for a 21-day
contract. Approximately 75,000 contracts for Brent crude oil
futures, representing about 75 million barrels, are traded
daily on the IPE.\89\
---------------------------------------------------------------------------
\89\ IPE, Introduction to the IPE, available on the IPE website, at
http://www.ipe.uk.com/include/downloads/brochures/
introduction%20to%20the%20IPE(screen).pdf.
---------------------------------------------------------------------------
d. Brent Over-the-Counter Markets
The peculiarities of the Brent market have created a demand
for several other types of financial instruments linked to the
price of Brent crude oil. Because the price of Brent futures
contracts on expiry are linked to prices on the 21-day market,
the price of a cargo of Brent at expiry of a futures contract
is fixed from 2 to 6 weeks in advance of the time when the oil
underlying the contract is actually loaded for delivery. This
time gap means there may be significant changes in the price of
a barrel of Brent crude between the expiry of a future contract
and when the barrel is loaded at the Sullom Voe terminal.
Two types of instruments were developed as tools for
hedgers and speculators to manage the risk of price changes in
the price of oil in the 2 to 6 weeks between when a futures
contract expires and the Brent is loaded. ``Contracts-for-
differences'' (CFDs) are contracts for the difference between
the price of dated Brent and the price of Brent in the first
forward month 15- or 21-day contract. By using a CFD, a buyer
or seller can effectively lock-in the price of dated Brent in
relation to the 21-day price, reducing exposure to changes in
the price of the cargo of Brent from the time the 21-day
contract expires and the time the cargo is loaded onto the
ship.
Because the price of dated Brent is the benchmark price,
plus or minus a quality differential, for a variety of crude
oils, a CFD is a useful tool, along with Brent futures
contracts, for the purchasers and sellers of these other Brent-
linked crude oil streams to hedge against the risks of changes
in the price of dated Brent. Brent futures contracts, by
themselves, leave the purchasers or sellers of crude oil linked
to dated Brent exposed to anywhere from 2 to 6 weeks of change
in the price of dated Brent. CFDs provide a hedge against these
changes in price. Hence, Brent CFDs have become a key risk-
management instrument in the crude oil trade.
As with the formal futures markets for crude oil, the CFD
market has grown rapidly since the early 1990's, and since the
mid-1990's, trading volumes in CFDs have been larger than for
both 15-day Brent and dated Brent. It is estimated that, by
1998, over three-fourths of non-futures Brent transactions were
in the form of CFDs, with the remainder in 15-day and dated
Brent.\90\ Brent CFDs are purchased and sold through brokers,
with daily quotes reported and published by Platts.
---------------------------------------------------------------------------
\90\ Crude Oil Handbook, supra, at B16.
---------------------------------------------------------------------------
In its description of CFDs, the Crude Oil Handbook reports
on the strengths and weaknesses of the CFD market, including
the incentives they may provide to manipulate underlying
weaknesses in the dated Brent market:
While CFDs would seem to be a perfect complement to
other Brent markets, these derivatives have come under
criticism since their inception as a vehicle for market
squeezes and as a source of price volatility. . . . The
main problem has been the large variation in price
between dated Brent and 15-day Brent. Ironically, the
possibility of hedging this exact risk with CFDs has
undoubtedly contributed to the growth of the market.
The emergence of CFDs did coincide with a period of
greater volatility in the spread between the dated and
15-day prices. While the CFD market is meant to hedge
that risk, it also may have prompted increased efforts
to manipulate price quotes for dated Brent. It also
seems to have contributed to squeezes in the forward
market, because it provides a way for the initiator of
a squeeze to make a profit unwinding the long position
that has been created in the forward market by taking
offsetting positions in CFDs before the squeeze gets
going.\91\
---------------------------------------------------------------------------
\91\ Id. at B17.
Another popular way to hedge the risk of divergence between
the price of dated Brent and the price of Brent futures on the
IPE is through the ``dated to front-line (DFL) swap.'' This OTC
instrument is similar to the CFD, but is the difference between
the price of dated Brent and the price of the next month's
Brent on the IPE. As with the CFD, DFL swap prices are tracked
and published on a daily basis by oil industry trade
publications. DFL swaps are bought and sold either through
brokers or directly between the parties.
Generally, the Brent OTC markets are either totally
excluded or substantially exempted from regulation under the
CEA. CFDs and DFLs that are traded between oil companies, Wall
Street firms, and crude oil traders could be considered swap
transactions, which under the CFMA are totally excluded from
regulation under the CEA. To the extent that OTC instruments,
such as 21-day Brent contracts, are traded on an electronic
exchange such as the ICE, such trades are exempt from all
regulation other than some of the bare-bones anti-fraud and
anti-manipulation provisions.
Each of the different spot, forward, futures, and over-the-
counter markets for Brent crude oil has evolved to address the
peculiar manner in which Brent crude oil is brought to the
market and the risks of price changes during the process.
Because of the importance of dated Brent as a benchmark for the
price of so much crude oil worldwide, the highly liquid IPE
futures market and OTC markets for CFDs and DFL swaps have
become popular mechanisms to spread risk and discover prices
for crude oil traded globally. However, in contrast to the
highly transparent Brent futures market to which they are
linked, at present there is little transparency in the market
for Brent OTC instruments.
2. West Texas Intermediate (WTI)
``It's not ideal, but it's what we've got.''
--A crude oil trader, commenting on the NYMEX WTI
contract, December 2002
WTI is the benchmark for approximately 12 to 15 million
barrels of crude oil produced or sold each day in the Western
Hemisphere. Except for crude oil produced in Alaska, nearly all
of the crude oil produced in the United States is priced off
WTI. About 80 percent of the crude oil imported into the United
States is priced off WTI.\92\
---------------------------------------------------------------------------
\92\ See Figure III-3. Because WTI is the benchmark for most of the
crude oil consumed in the United States, exporters of North Atlantic
basin crudes priced off Brent often will quote the prices in relation
to WTI to facilitate price comparisons for U.S. importers.
---------------------------------------------------------------------------
Although more crude oil worldwide is priced off Brent than
WTI, the standard NYMEX WTI contract is the most widely traded
commodity futures contract in the world. Approximately 150,000
contracts for WTI are traded daily on the NYMEX, representing a
volume of crude oil equal to nearly twice the world's daily
production.
WTI is actually a blend of crude oils produced in oil
fields in Texas, New Mexico, Oklahoma, and Kansas. These crude
oils all have relatively low sulfur levels and are relatively
low in density. Like Brent, the production of WTI is dwindling.
Ten years ago, around 750,000 barrels of WTI were produced
daily; presently, around 400,000 barrels of WTI are produced
daily. Future production is expected to decline.\93\
---------------------------------------------------------------------------
\93\ Subcommittee interviews, 2002.
---------------------------------------------------------------------------
As a result of the historical development of Cushing,
Oklahoma, as a transportation and storage hub for crude oil
produced in the region, the standard NYMEX futures contract for
light sweet crude oil provides for the delivery of WTI or
several comparable alternative grades at that location.
Presently, there are about 20 million gallons of storage
capacity at Cushing and an extensive network of crude oil
pipelines leading into and out of these facilities. However,
Cushing is landlocked, far from the ports handling oil imports
and exports, and no longer the central distribution point it
once was for crude oil produced in the United States.
Numerous industry participants are concerned about the
potential for distortion--either intentional or unintentional--
of WTI pricing due to the limited volume of WTI produced each
month, the relative isolation of Cushing from global trade, and
limits on Cushing's pipeline and storage capacity. Like Brent,
the production of WTI is half of what it once was. Like Brent,
the constrained logistics of WTI production, transport, and
storage can make the availability of WTI subject to artificial
bottlenecks or surges in supply.
One of the most frequently raised issues regarding the WTI
benchmark is that 80 percent of the tank storage capacity at
Cushing, Oklahoma is controlled by two companies, BP and Shell.
Figure III-5 shows one industry estimate of the division of
ownership of the crude oil storage tanks at Cushing. Because
crude oil inventories in the Midwest strongly affect WTI
prices, the concern is that the actions of these two firms
regarding their storage tanks at Cushing may have a
disproportionate impact on Midwestern supplies and inventories
and hence on the price of WTI.
[GRAPHIC] [TIFF OMITTED] T5551.151
Many oil companies and traders do not consider the WTI
price at Cushing, Oklahoma, to accurately reflect global supply
and demand, and therefore do not rely solely on the price of
WTI as a reference price to determine whether to import crude
oil from Europe or west Africa. These companies and traders
also use the price of Light Louisiana Sweet (LLS) crude oil,
which is delivered on the Gulf Coast, to gauge whether it is
profitable to import crudes from across the Atlantic (with
attendant transportation costs) or instead purchase domestic
crudes.\94\
---------------------------------------------------------------------------
\94\ The addition of several new futures contracts for trading on
the NYMEX OTC trading platform, including a LLS futures contract,
indicates there may be sufficient market demand for futures contracts
that can more precisely hedge crude oil costs than can be done with
just a NYMEX WTI contract. As the Brent market shows, however, a
proliferation of OTC instruments that complement an exchange-traded
futures contract can obscure the price discovery function of the basic
futures contract, expose the underlying exchange-traded contract to
price distortions created in the OTC market, and introduce additional
barriers to market transparency since OTC prices are not required to be
published and may not always be widely available.
---------------------------------------------------------------------------
3. Dubai
Generally, crude oil purchased in Asia, most of which
originates in the Middle East, is priced off the Dubai
benchmark. This benchmark price is calculated from the price of
crude oils produced in both Dubai and Oman. Approximately 10-15
million barrels per day of crude oil are priced off the Dubai
benchmark. Only a small fraction of U.S. crude oil imports are
linked to the price of Dubai oil.
Initially, the Dubai benchmark price was calculated solely
on the basis of the price of crude oil produced in Dubai.
However, as production declined from around 350,000 barrels per
day 10 years ago to around 200,000 barrels per day in recent
years, the Dubai market became volatile and susceptible to
manipulation. In 2001, Platts added Omani crude oil to the
benchmark formula, which effectively doubled the amount of
crude oil underlying the calculation. The inclusion of Omani
crude oil in the benchmark calculation immediately reduced the
volatility of the price of Dubai.
Just as crude oil purchasers located in the United States
use the difference between the price of Brent and the price of
WTI as a major factor in determining whether to import crudes
from Europe and west Africa, purchasers in Asia use the
difference between the price of Brent and the price of Dubai as
a major factor in determining whether to export European and
west African crudes to Asia. Hence, the price of Brent is a
critical component of the entire global crude oil trade, and
the relative price of the three benchmarks is a major factor
determining the global flow of crude oil.
C. The Vulnerability of the Brent Market to Squeezes
``If you have to ask who the chump is, you're it.''
--Alleged Remark of a Crude Oil Trader following
Brent Squeezes in 2002
As production of Brent crude oil has dwindled, the number
of Brent cargoes leaving the Sullom Voe terminal declined from
about 60 cargoes per month a decade ago to only about 20
cargoes per month, or less than 1 per day, by the first half of
2002. This drop in the number of cargoes made the Brent market,
prior to the addition of the Forties and Oseberg grades to the
Brent pricing mechanism in mid-2002, prone to squeezes by
making it possible for a single company to purchase most of the
Brent production in a given month. As Horsnell and Mabro
observed in their textbook on the Brent market, ``it is much
easier and more tempting to squeeze a twenty cargo loading
programme in a month than a sixty cargo programme.'' \95\
---------------------------------------------------------------------------
\95\ Paul Horsnell and Robert Mabro, Oil Markets and Prices 138
(Oxford University Press, 2000).
---------------------------------------------------------------------------
One large-scale squeeze of the Brent market occurred in the
summer of 2000, in an episode that is commonly referred to as
the ``Arcadia squeeze.'' This squeeze disrupted the Brent
market and led to spikes in the prices of crude oil priced off
Brent, reportedly costing U.S. refiners tens of millions of
dollars. The magnitude of the Arcadia squeeze surprised market
observers and alerted the market to possible means and
consequences of manipulating the price of Brent.
Arcadia, a wholly owned subsidiary of the Japanese Mitsui
Corporation, is a crude oil trading company, doing business
principally in London and Geneva, and is active in the global
and Brent crude oil markets. In September 2000, the Tosco
Corporation, a refining company that has since been merged into
what is now Philips-Conoco, sued Arcadia for $30 million in
damages due to the higher costs for crude oil resulting from
Arcadia's alleged manipulation of the Brent market.\96\
According to Tosco, Arcadia and other crude oil traders
``pursued a complex scheme to monopolize the September Brent
Crude sub-market, thereby manipulating the entire September
[2000] Brent Indexed market.'' \97\ Tosco further alleged,
``Arcadia knew at all times relevant that, by manipulating the
Platts price for Brent crude, it would in turn manipulate
prices for crude oil being purchased for delivery to the
eastern United States.''
---------------------------------------------------------------------------
\96\ Tosco Corp v. Arcadia Petroleum Ltd., (D.C. S.D.N.Y.)
Complaint, Sept. 7, 2000.
\97\ Tosco's complaint described the use and purpose of 15-day
Brent contracts in a manner akin to futures contracts:
``15-day Brent'' transactions are paper transactions involving
the sale or purchase of cargoes for delivery on an unspecified day of a
given future month. The cargo becomes deliverable when the seller gives
15 days notice to the buyer. Notice often travels down a chain of
subsequent traders until one chooses to accept physical delivery of the
cargo. Because 15-day Brent transactions do not initially require
physical delivery, they are frequently traded for hedging and
speculation purposes.
---------------------------------------------------------------------------
Because Arcadia settled with Tosco several weeks after the
lawsuit was filed in a confidential settlement, Tosco's
complaint and contemporaneous press reports of the lawsuit are
the main public sources of information about Arcadia's trading
activities during this period.\98\ In addition, however,
Arcadia's Brent trades left a trail of price spikes in the
Brent spot, futures, and over-the-counter markets. These price
spikes are consistent with the price spikes left by squeezes in
other commodity markets.
---------------------------------------------------------------------------
\98\ The Subcommittee staff requested an interview with Arcadia to
provide it with an opportunity to clarify or supplement the record
regarding Tosco's allegations of manipulation and antitrust violations.
Arcadia declined to meet with the Subcommittee staff on any of the
several dates proposed. Arcadia, which is organized outside the United
States, is the only company trading crude oil that did not cooperate
with Subcommittee requests for information in this investigation.
---------------------------------------------------------------------------
In its complaint, Tosco outlined how Arcadia allegedly
manipulated the limited Brent market:
Arcadia effectuated its scheme by obtaining control
of the market for 15-day Brent contracts for September
2000 delivery. Arcadia did so by surreptitiously
purchasing more 15-day Brent contracts for September
delivery than it knew could be physically delivered in
September. Only a finite number of shipments of Brent
crude are available for delivery in any given month. In
conspiring to control the September Dated Brent market,
Arcadia and its coconspirators were undoubtedly aware
that, due to a market abnormality, only 22 deliveries
of Brent oil would be available in September, much
fewer than would be available in a typical month.
Tosco asserted that Arcadia and its coconspirators used
this ``monopoly power'' over the September deliveries of Brent
oil to raise the price of Brent crude oil and all other crude
oils indexed to the price of Brent ``higher than would result
from the ordinary functioning of the market.'' According to
Tosco, ``From August 21 to September 5, the price of Brent
crude increased by $3.33 per barrel, including a 1-day leap of
$2.38 per barrel between August 24 and 25.'' Moreover, said
Tosco, ``In a conversation with a Tosco trader, an Arcadia
trader stated that Arcadia controlled the September market for
Brent crude, that Arcadia had raised the price of September
Brent Crude by approximately $3.00 per barrel and that Arcadia
could raise the September price further than it already had.''
``By causing September Brent Crude prices to spike,'' Tosco
declared, ``Arcadia's squeeze on the market caused injury to
every buyer in the September Brent Indexed market.''
Arcadia has told the London IPE that all of its Brent
trades during this period had valid commercial
justifications.\99\ Similarly, Glencore International, one of
Arcadia's alleged coconspirators, acknowledged that Arcadia
bought large amounts of Brent crude in August and September
2000, but asserted that these trades were undertaken for a
valid commercial reason--to fulfill specific contracts for
Brent crude oil. According to Glencore, ``the need to supply a
crude contract to India'' was one of the reasons for the large
purchases of September Brent.\100\
---------------------------------------------------------------------------
\99\ Interview with IPE officials, November 2002.
\100\ Ross McCracken, Esa Ramasamy, Beth Evans, Brent Row Escalates
as Unipec Suspends Trading with Arcadia, Platt's Oilgram News,
September 13, 2000.
---------------------------------------------------------------------------
Although Arcadia and Glencore asserted there were valid
commercial reasons for Arcadia's near-monopolization of the
September 2000 Brent market, others were skeptical. According
to Platt's, ``India's Ministry of Petroleum and Natural Gas
asked its refiners at the end of August to reduce runs due to a
drop in demand.'' \101\ ``Something is amiss,'' Philip Verleger
wrote in late August 2000, ``On the one hand traders claim the
oil is needed in India. On the other hand, India does not
really need the oil.'' \102\
---------------------------------------------------------------------------
\101\ Id.
\102\ Id.
---------------------------------------------------------------------------
The effects of Arcadia's purchase of large amounts of Brent
cargoes in August and September 2000--whether a legal squeeze
or an ``abusive'' one \103\--can be seen in a number of price
charts. The data shows that the Arcadia squeeze raised, not
only the spot price of Brent in August and September of 2000,
but also the price of the futures contracts sold in August and
September for the delivery of Brent crude oil in September and
October. These price increases, in turn, raised the price of
Brent OTC instruments whose value was linked to the spot and
futures prices. The resulting price spikes are clearly
observable in crude oil price data over this time period.
---------------------------------------------------------------------------
\103\ Whether Arcadia and Glencore had a legitimate commercial need
for the large amounts of Brent crude purchased in August and September
2000 is critical to any determination, under U.S. law or U.K. law, on
whether the Brent market was illegally manipulated. Under both U.S. and
U.K. commodities law, manipulation will be found only if congestion in
the market is not the natural result of supply and demand conditions in
the market, but was intentionally created by a trader for the specific
purpose of creating an artificial price. Accordingly, in this Report
the use of the term ``squeeze'' does not connote illegal activity,
unless there are additional elements present that amount to an
``abusive squeeze'' or ``manipulation.'' See Appendix 1 for a more
detailed discussion of the law of manipulation.
---------------------------------------------------------------------------
Figure III-6 shows the increases in both the spot price of
Brent and the price of the expiring Brent futures contracts
resulting from the Arcadia squeeze of the Brent market in
August and September 2000.
[GRAPHIC] [TIFF OMITTED] T5551.019
A sharp increase in the price of the nearest futures
contract as the current contract nears expiry is a classic sign
of a squeeze.\104\ This spike in the price of the near-term
contract occurs because towards the expiry of a futures
contract the ``shorts''--those who must deliver the commodity
to the ``longs'' when the next-month contract expires--must
either purchase the physical commodity to make delivery or pay
those expecting delivery--the ``longs''--to cancel out the
obligation to deliver. In a squeeze, the supply of the physical
commodity is in scarce supply, especially as compared to the
outstanding contracts to deliver, so that the ``shorts'' have
no alternative but to pay the ``longs'' for their expiring
futures contracts to cancel their obligation to deliver the
commodity.\105\ Because the shorts are legally obligated to
either deliver the commodity--of which there is insufficient
amount to supply all of the outstanding contracts--or purchase
the contracts from the longs to cancel the obligation for
delivery, the longs can ``squeeze'' the shorts for a high price
for the purchase of the long contracts.
---------------------------------------------------------------------------
\104\ Stephen Craig Pirrong, The Economics, Law, and Public Policy
of Market Power Manipulation, 148 (Kluwer Academic Press 1996).
\105\ ``He that sells what isn't hisn
Must buy it back or go to prisn.''
Attributed to Commodore Vanderbilt, in Edwin Lefevre,
Reminiscences of a Stock Operator, 236 (Wiley, 1994).
---------------------------------------------------------------------------
Because a squeeze creates a near-term shortage of the
commodity, and not a fundamental change in the long-term supply
or demand for the commodity, another tell-tale sign of a
squeeze is an increase in the price of the commodity for near-
term delivery as compared to the price of the commodity for
delivery farther out in the future.\106\ When a commodity price
is higher for near-term delivery than for later delivery, the
price curve of the commodity is said to be in
``backwardation.'' When the commodity price for later delivery
is higher than for delivery in the near future, the price curve
for the commodity is said to be in ``contango.'' A sudden shift
from contango to backwardation and a sharp increase in an
already backwardated market are also classic signals of a
squeeze.
---------------------------------------------------------------------------
\106\ Pirrong, at 147; Jeffrey Williams, Manipulation on Trial, 83
(Cambridge University Press, 1995); Horsnell and Mabro, at 132.
---------------------------------------------------------------------------
As Figure III-7 illustrates, during the Arcadia squeeze the
Brent futures market became sharply backwardated, with near-
term prices exceeding prices for later deliveries.
[GRAPHIC] [TIFF OMITTED] T5551.020
In addition, price data shows that Brent prices rose
sharply compared to WTI prices. This change in relative prices
shows that the increased Brent price was not due to worldwide
pressures on crude oil markets, but rather to events that
affected only the Brent and not the WTI market. During a
squeeze, the price of the squeezed commodity will increase in
relation to the price of similar commodities that are not
squeezed.\107\ Although the demand, and hence price, of
related, substitutable commodities may also increase as the
squeezed commodity becomes scarce and buyers seek alternative
supplies, the primary effects of the squeeze are seen by
comparing the price of the squeezed commodity to the price of
similar but ``unsqueezed'' commodities.
---------------------------------------------------------------------------
\107\ Pirrong, at 146; Williams, at 87.
---------------------------------------------------------------------------
Figure III-8 shows that during the Arcadia squeeze the
price of Brent crude oil rose sharply in comparison to the
price of WTI. This is strong evidence that the price rise that
occurred at the time was caused by a distortion in the market
for Brent crude oil, rather than some other factor affecting
the general global supply and demand for crude oil.
[GRAPHIC] [TIFF OMITTED] T5551.021
The relationship between Brent and WTI is a major factor
determining the volume and price of crude oil imported into the
United States. Normally, Brent sells for about $1.50 per
barrel, on average, less than WTI. Because it costs on average
between $1.00 and $1.50 per barrel to transport a very large
tanker of crude oil from the North Sea across the Atlantic
Ocean to ports in the United States, Brent is generally price-
competitive with WTI only when it is priced at about $1.50 per
barrel less than WTI. When the price of Brent plus the costs
for shipping Brent to the United States is less than the price
of WTI, the transatlantic ``arbitrage'' is said to be ``open,''
meaning that Brent and other crudes priced off Brent will be
less expensive than WTI.\108\ Lower costs for importing Brent
mean U.S. imports of these crude oils will be more attractive
for U.S. refiners, who will then increase their purchases of
Brent and other crudes priced off Brent. When the price of a
barrel of Brent plus transportation costs is greater than the
price of WTI, it is less economical to import Atlantic basin
Brent-based crudes, and the transatlantic ``arbitrage'' is said
to be ``closed.'' U.S. refiners then import less crude from the
North Atlantic and rely more on their inventories and crude
oils that are produced in North and South America and priced
off WTI.
---------------------------------------------------------------------------
\108\ Importers also consider the relationship between the price of
WTI and the price of other domestic grades.
---------------------------------------------------------------------------
An article by a crude oil trader for a major U.S. oil
company posted on the NYMEX website describes the significance
of the Brent-WTI price difference as follows:
Several times during the year, the market provides
price incentives for the Atlantic Basin sweet
production to flow west. The Brent/WTI spread is the
``roadmap'' the industry studies to determine if the
arbitrage is open or closed. The status of the
arbitrage is one of the driving factors determining the
structure of the forward WTI and refined product market
price curves in the United States and Europe. An open
export market for Brent implies tighter supplies for
the United States, and the reverse is true when the
barrels are priced to stay in Europe.\109\
---------------------------------------------------------------------------
\109\ Kinnear, The Brent/WTI Arb: Linking the World's Key Marker
Crudes (NYMEX website). This article further describes how the closing
of the Brent/WTI arbitrage, which results in a reduction in the amount
of Atlantic basin crude oil imported into the United States, can have a
significant effect on U.S. crude oil prices:
LDeliveries of Brent to the U.S. Gulf Coast and East Coast of
Canada can reduce demand for domestic sweet barrels including WTI. When
the trans-Atlantic sweet crude arbitrage to the United States is
completely closed, there is typically a draw on sweet crude
inventories; WTI volatility increases as does the probability of a
market distortion.
Figure III-9 shows, for a typical 12-month period during
the 1990's, the relationship between the spot prices of Brent
and WTI. During this period Brent and WTI spot prices closely
tracked each other over a wide range of prices--from a low of
$9 to a high of about $19 per barrel. On average, WTI was $1.86
more expensive than Brent. At no time was Brent more expensive
than WTI.\110\
---------------------------------------------------------------------------
\110\ The standard deviation of the Brent-WTI price difference
during this 12-month period was about 44 cents; hence about 68 percent
of the time the price of Brent was between $1.42 and $2.32 less than
WTI; and 95 percent of the time Brent was between 98 cents and $2.76
less than WTI. The co-efficient of correlation between Brent and WTI
prices during this period, ``R'', is 0.981, indicating a high
correlation between the two markets (R=1 indicates a perfect
correlation).
[GRAPHIC] [TIFF OMITTED] T5551.022
As Figure III-8 shows, during the Arcadia squeeze the price
of Brent rose to nearly $3.00 per barrel more than WTI. As
Tosco's complaint states, such an increase in the price of
Brent would make other Atlantic basin crude oils priced off
Brent significantly more expensive for U.S. refiners. As the
price of Brent rose to artificially high prices, U.S. refiners,
such as Tosco, had to pay more for their imports that were
indexed to the price of Brent.
Figure III-10 shows the price difference between Brent and
WTI from January 1992, through December 2000. The data shows
that, on average over this 9-year period, Brent cost $1.46 less
than WTI. The data also shows that, in 2000, the Arcadia
squeeze raised the price of Brent compared to WTI to
extraordinary levels when compared with the prior Brent-WTI
relationship.
[GRAPHIC] [TIFF OMITTED] T5551.023
Due to the peculiarities of the Brent market, a trader
seeking to acquire a large number of Brent cargoes at some
month in the future must acquire 21-day contracts to obtain the
physical cargoes, as well as futures contracts and OTC
instruments to hedge against the price increases that can be
expected to follow from the increased market demand for Brent
caused by the trader. As explained earlier, crude oil traders
use Brent derivatives called contracts-for-differences (CFDs)
and dated-to-frontline (DFL) swaps to hedge Brent price
risks.\111\
---------------------------------------------------------------------------
\111\ A CFD is the difference between the price of dated Brent
(``spot price'') and the price of the 15- or 21-day contract needed to
obtain a physical cargo of Brent. A DFL swap is the difference between
the price of dated Brent and the price of the expiring IPE contract.
See Section III.B.
---------------------------------------------------------------------------
A squeeze in the Brent market will increase the price of
CFDs and DFL swaps, since the values of these over-the-counter
derivatives are linked to the spot and futures prices for
Brent. As the price of the near-term futures contract increases
in a squeeze, the price of the related OTC Brent derivatives
will also increase. Figure III-11 shows that, during the
Arcadia squeeze, the relative price of the Brent first month
futures contract increased compared to the price of dated
Brent, indicating a spike in the price of a DFL swap.
[GRAPHIC] [TIFF OMITTED] T5551.024
In addition to sharp price increases, Figures III-6, 7, 8,
10, and 11 also show classic price ``drop-offs'' after the
squeeze is ended. A sudden drop in the spot price of a
commodity or the price of a futures contract right after expiry
of the contract is yet another indication of a short-term
squeeze in the market for that commodity. Following the run-up
at expiry in the price of the squeezed commodity and the
expiring futures contract, the price of the commodity and the
futures contracts rapidly fall to reflect the normal supply and
demand in the market. Price spikes caused by factors other than
squeezes do not normally cluster around the expiry of a futures
contract.\112\
---------------------------------------------------------------------------
\112\ Pirrong, at 147; Horsnell and Mabro, at 132.
---------------------------------------------------------------------------
The magnitude of the Arcadia squeeze surprised market
observers. ``In the 20 years that I've been following the oil
market, this is probably the most extreme example of an
artificial price being created that I've observed that has
persisted for as long as this one persisted,'' said oil
economist Philip Verleger at the time.\113\ Another petroleum
economist, University of Houston Professor Michael Economides,
stated at the time, ``The idea that one could corner, could
encompass an entire benchmark market and, consequently,
manipulate potentially other prices is absolutely fascinating
and, in my view, astonishing. We certainly have not been
confronted with a situation like this, to my knowledge, in the
history of the petroleum industry.'' \114\
---------------------------------------------------------------------------
\113\ National Public Radio, All Things Considered, October 3,
2000.
\114\ Id.
---------------------------------------------------------------------------
Others, however, viewed Arcadia's squeeze and the use of
derivatives to profit from the Brent squeeze as business-as-
usual in the petroleum markets. Commenting on Arcadia's effect
on the market, the Oil Daily wrote, ``[T]he manipulation of
dated Brent by trading houses, who skillfully engineer gains in
derivatives markets, sometimes by sacrificing losses in
physical markets, has evolved into a high art. And it is not
only buyers of Brent that are affected. Buyers of Nigerian or
other Brent price-linked crude grades exported to the US could
argue that they too had been harmed by the manipulation of the
Brent market.'' \115\
---------------------------------------------------------------------------
\115\ Paul Merolli, Stephen MacSearraigh, Tosco Sues Arcadia for
Brent Manipulation, Oil Daily, September 11, 2000.
---------------------------------------------------------------------------
The price data during the period of the Arcadia squeeze
demonstrates that a squeeze can spike prices not only in the
crude oil spot and futures markets, but also in the OTC
markets. The extent to which Arcadia profited from the squeeze
caused by its activity in the Brent market is not known.
Robert Mabro, Director of the Oxford Institute for Energy
Studies, and one of the foremost authorities on the Brent
market, contends the OTC Brent market facilitates squeezes, and
enables traders to artificially create profits from the
weaknesses in the market. According to an interview of Dr.
Mabro reprinted by the Derivatives Study Center in 2000:
``A typical Brent squeeze involves a company quietly
building a strong position in short-term swaps called
contracts-for-differences, or CFD's, for a differential
not reflected in current prices. The company then buys
enough cargoes in the dated Brent market to drive the
physical crude price higher, which boosts the CFD
differential,'' Mabro said. ``The company may lose
money on the physical side, but it's more than
compensated from profits on its offsetting paper
position in the short-term swaps market,'' Mabro said.
``The whole trick is to collect more money in CFD's
than you lose on the physical squeeze,'' Mabro said.
``People seem to do it in turn. It depends on who's
smart enough to move in a way that nobody notices until
it happens.'' \116\
---------------------------------------------------------------------------
\116\ Derivatives Study Center, Not Learning the Lessons of Long-
Term Capital's Failure, September 2000.
In another article, Dr. Mabro concluded that the variety of
financial instruments and the complexity of the Brent market
magnifies the vulnerability of the Brent market to squeezes and
---------------------------------------------------------------------------
price distortions:
The array of instruments available to traders enable
a small number of powerful and sophisticated players to
operate squeezes or launch other operations which
causes prices to move in directions do not always
reflect the actual state of the supply/demand balance.
Whether these ``games'' whose frequency has been
increasing in recent years affect price trends over the
medium term is debatable. It is certain, however, that
they cause higher price volatility, and that they rob
prices from their most important function which is to
signal at every movement the state of the supply/demand
balance.\117\
---------------------------------------------------------------------------
\117\ Robert Mabro, Oil Markets and Prices, OIES Monthly Comment,
August 2000. Dr. Mabro's comments were written prior to the
implementation of the BFO contract. In an interview with the
Subcommittee staff in December 2002, Dr. Mabro stated that the new BFO
contract could help prevent the particular types of squeezes in the
Brent market to date, but that squeezes were ``endemic'' to all
commodity markets. Dr. Mabro stated that the limited number of players
in the crude oil markets, together with the lack of transparency in the
OTC markets, continued to present risks to the efficiency and
transparency of the market.
Dr. Mabro and others point to profit-taking in OTC
derivatives as a major source of gain for traders attempting to
squeeze the crude oil markets. Price data tracing OTC price
increases and documenting OTC trading gains is unavailable,
however, due to the lack of price transparency and disclosure
requirements in OTC markets.
Dr. Mabro observes that large players in the crude oil
markets have little incentive to improve the operation of the
markets, and this situation harms U.S. interests and consumers:
Traders like [the current situation] because they all
think that it provides them with opportunities to make
money. . . . Whether the system is good for the
exporting countries, the oil companies, the importing
countries, the US government and the final consumer is
very doubtful. Judging from recent experience it is
clear that nobody likes either very high or very low
oil prices. When they obtain, it is far too easy to
blame OPEC. The issue however is not OPEC on its own
but the system in its complex operation, in the links
between various markets, and the awkward relationship
between markets and OPEC. A fundamental reform is
required.\118\
---------------------------------------------------------------------------
\118\ Id.
IV. CASE STUDY: THE COSTS OF FILLING THE SPR IN SPRING 2002
``In the long run commodity prices are governed but
by one law--the economic law of demand and supply. The
business of the trader in commodities is simply to get
facts about the demand and the supply, present and
prospective.''
--Edwin Lefevre, Reminiscences of a Stock
Operator, 1923
A. Introduction
In February 2002, DOE reversed its policy of routinely
granting requests to defer oil shipments to the SPR when crude
oil prices were high and market supplies were tight.\119\ DOE
made this policy change after receiving a request by an oil
company in February to defer shipments due to be delivered to
the SPR later in the spring. Senior DOE officials instructed
the SPR Office to deny the oil company's request.
---------------------------------------------------------------------------
\119\ See Section II of this Report.
---------------------------------------------------------------------------
During DOE's consideration of this deferral request, SPR
career officials warned senior DOE officials, including the
Deputy Secretary of Energy, that filling the SPR when oil
prices were high or oil supplies were tight could drive oil
prices higher, reduce U.S. commercial inventories, and hurt
U.S. consumers and taxpayers, and advocated returning to the
prior market-based policy.\120\ Despite these warnings, DOE
decided to keep the no-deferral policy in place for most of
2002. DOE made this decision without conducting any cost-
benefit analysis of the new policy, without analyzing the
relative costs of the new policy compared to the prior policy,
and without preparing a detailed analysis of the new policy's
potential impact on overall U.S. oil supplies.\121\ DOE has yet
to track the actual costs associated with the new policy.
---------------------------------------------------------------------------
\120\ See Section V of this Report.
\121\ The Subcommittee asked DOE to produce all documents
containing any cost-benefit analysis related to the new policy, and was
informed by DOE that none exist. In fact, DOE was unable to produce a
single document explaining or justifying the policy decision to stop
granting requests to defer oil shipments to the SPR.
---------------------------------------------------------------------------
This Section provides a case study illustrating how the new
SPR policy became a major factor contributing to higher crude
oil prices in the United States in the spring of 2002, which
led to increases in the price of various petroleum products,
such as heating oil, diesel fuel, and jet fuel. It focuses on
the period from mid-November 2001, when DOE began to add
substantial amounts of oil to the SPR, through mid-May 2002, 6
months later. In particular, the case study traces how the
large demands placed on the Brent market in late 2001 and early
2002 due to purchases of Brent cargoes for shipment to China
and the SPR increased Brent prices in early 2002. DOE's change
in policy to not allow any deferrals of SPR shipments was a
major factor contributing to the tightness of the Brent market
in the spring of 2002, and helped boost the price of Brent and
crude oils priced in relation to Brent.
The case study details how these higher Brent prices
translated into higher costs for imported crude oil, lower U.S.
crude oil inventory levels, and a sudden, sharp increase in the
futures and spot prices for WTI crude oil in April and May. The
case study then shows how this spike in the price of WTI drove
up the price of heating oil, jet fuel, and diesel fuel, and
briefly explains how increases in the prices of these petroleum
products hurt U.S. consumers and businesses. The case study
also shows how the elevated crude oil prices decreased U.S.
refining margins and increased economic pressures on U.S.
refiners in the second quarter of 2002. The case study finds
that, in just 1 month alone, the new SPR fill policy imposed
additional crude oil costs on U.S. consumers and businesses of
between $500 million and $1 billion. These 1-month costs were
the most directly visible and quantifiable of the additional
costs created by the SPR program during these months.
DOE's actions to fill the SPR were not the only factor
pushing up crude oil prices in the spring of 2002. Factors such
as Saddam Hussein's 1-month suspension of Iraqi oil exports in
April 2002, an 8-day oil strike in Venezuela, OPEC production
cuts in the first quarter of 2001, and speculation and concern
over impending war with Iraq also affected oil prices.
Nonetheless, the evidence shows DOE's new policy to deposit oil
into the SPR regardless of the price of oil was an additional
major factor driving up U.S. oil prices and hurting U.S.
consumers in the spring of 2002.
B. Analysis
1. Large Amounts of Brent Crude Oil Were Put Into the SPR in Late
2001 and Early 2002
From November 2001, when DOE began its recent program to
fill the SPR to 700 million barrels, through the second quarter
of 2002, most of the oil deposited into the SPR was Brent crude
oil. As can be seen in Figure IV-1, Brent crude oil accounted
for about 25 of the 29 million barrels, or nearly 85 percent,
of the sweet crude deposited into the SPR during this
period.\122\ Although each company had the option of delivering
a variety of light sweet crude oils to the SPR, each one
deposited mostly Brent.
---------------------------------------------------------------------------
\122\ See also Figure II-3.
---------------------------------------------------------------------------
Crude oil traders interviewed by the Subcommittee stated
that Brent was the most economical choice to place in the SPR
for a number of reasons. These traders explained, first, that
Brent is the most widely traded of the sweet crude oils that
may be placed into the SPR, thus making it easiest to obtain.
Secondly, some said that the variety of Brent instruments that
are traded--21-day contracts, futures contracts, CFDs, and DFL
swaps--makes it possible to hedge against changes in the price
of Brent cargoes more precisely than for other types of crude
oil. They stated that the use of other grades of crude oil
presented basis risks (risks in the divergence between the
price of the grade of crude oil and the price of dated Brent)
that did not exist when Brent itself was used. Third, many of
the companies depositing crude oil into the SPR during this
period were major players in the Brent market, and their
traders stated that acquiring physical Brent cargoes was, and
is, a core part of their business. Fourth, according to some
traders, it was physically easier to load large cargo ships at
the Sullom Voe terminal than at other North Sea terminals. All
of the traders interviewed by the Subcommittee staff denied
their purchases of Brent were intended to increase oil prices
by creating a shortage of Brent.
As can be seen in Figure IV-1, however, beginning in July
2002, much less Brent, relative to other sweet crudes, was
placed into the SPR. It is not clear which additional factors
made Brent so much more attractive for satisfying SPR
obligations in the first half of 2002 than in the second half
of the year. Section V.C. of this Report discusses whether oil
companies and traders may have acquired large amounts of Brent
crude oil in order to take advantage of the vulnerability of
the Brent market to squeezes that existed through the first
half of 2002.
[GRAPHIC] [TIFF OMITTED] T5551.025
In addition to the demand for Brent created by the SPR
program, in early 2002, two companies purchased large amounts
of Brent for shipment to China. Sempra Energy Trading and
Sinochem acquired all of the Brent cargoes loaded in February
2002, and sent 20 of these cargoes to China. According to
Sempra officials interviewed by the Subcommittee staff, a
narrowing of the price differential between Brent and Dubai
crude oils in late 2001 had made Brent relatively inexpensive
compared to the sour Middle Eastern grades, which led Chinese
refiners to purchase these large amounts of Brent. These
shipments of Brent to China tightened market supplies just as
DOE was announcing new contracts to fill the SPR. In the spring
of 2002, with the Brent market unsettled by the large shipments
to China, the market was further disturbed by reports that
large amounts of Brent were being sent to the SPR.
Figures IV-2 and IV-3 show the shippers and destinations
for the Brent cargoes loaded from January through May 2002.
Koch's Brent loadings in January, Shell's loadings in March and
April, and BP's loadings in May went primarily to the SPR.
Viewed together, Figures IV-1 through IV-3 demonstrate that an
unusually large portion of the Brent crude oil produced from
November 2001 through June 2002 was deposited in the Strategic
Petroleum Reserve.
[GRAPHIC] [TIFF OMITTED] T5551.152
[GRAPHIC] [TIFF OMITTED] T5551.153
2. The Use of Brent To Fill the SPR Increased the Price of Brent
Relative to WTI
The prices of the two major benchmarks, Brent and WTI,
generally rise and fall together, reflecting changes in global
supply and demand.\123\ Brent normally costs about $1.50 per
barrel less than WTI.\124\ From November 2001 through May 2002,
the price of Brent rose significantly relative to the price of
WTI.
---------------------------------------------------------------------------
\123\ See Figure III-9.
\124\ See Section III.
---------------------------------------------------------------------------
Figure IV-4 shows the price of Brent rose significantly
relative to WTI at about the same time as Brent cargoes began
to be sent to the SPR. From 1992 through September 2001, the
average difference in price between WTI and Brent was $1.49;
from November 2001 through May 2002, the average price
difference was 75 cents. In other words, from November 2001
through May 2002, the price of Brent rose 75 cents relative to
the price of WTI, cutting in half the normal differential
between the two benchmarks.
[GRAPHIC] [TIFF OMITTED] T5551.028
Figure IV-4 also shows that on a number of dates in this
period the price of Brent rose above the price of WTI. Several
of these mini-spikes in the price of Brent appear to have been
caused by announcements related to the SPR program: DOE's
January 22, 2002 announcement opening the bidding for the RIK
contract; DOE's February 11, 2002 announcement of the award the
RIK contract for light sweet crude oil; and BP's announcement
on April 18, 2002 that it was sending shipments of Brent to the
SPR.
[GRAPHIC] [TIFF OMITTED] T5551.029
Figure IV-5 places the relative Brent price increase in a
historical context. As can be seen from Figure IV-5, for the 7
months from November 2001 through May 2002, the price of Brent
was higher in relation to WTI for a longer period than at any
other time during the previous 10 years. For most of this 7-
month period, the price of Brent had risen between 60 cents and
$1.20 in relation to WTI, which is between one and two standard
deviations above the previous norm. For 2\1/2\ weeks in late
January and early February 2002, the price of Brent rose to
within 33 cents of WTI, which is a variation of more than two
standard deviations from the norm. These are statistically
significant price changes, and it is no mere coincidence that
they took place at the same time as the demands placed on the
Brent market from the SPR and China.
Additional price data provides evidence that the large
demands on the Brent market from China squeezed the Brent
market in January, and the large demand for Brent for the SPR
squeezed the Brent market from mid-March through early May. As
Section III explains, in a squeeze the supply of the physical
commodity is in scarce supply as compared to the outstanding
contracts to deliver, so that the ``shorts'' must either bid up
the price of the commodity to obtain it for delivery or pay a
high premium to the ``longs'' to cancel their obligation to
deliver the commodity.\125\ The fact that the Brent market was
squeezed can be seen by examining the Brent-WTI relationship
during this period, the price of near-term and longer-term
Brent futures, and the price of Brent OTC DFL swaps. Viewed
together, this evidence demonstrates the acquisition of large
amounts of Brent in early 2002, due to shipments of Brent to
China and the SPR, squeezed the Brent market, first in January,
and then again from mid-March to early May, in the same manner
as the Arcadia shipments of Brent to India had done in 2000.
---------------------------------------------------------------------------
\125\ See also Appendix 1.
---------------------------------------------------------------------------
One classic sign of a market squeeze is a sharp and sudden
increase in the price of one commodity in relation to the price
of similar commodities. Figures IV-4 and IV-5 demonstrate that
the price of Brent increased significantly relative to the
price of WTI shortly after Brent began to be used for SPR
deposits, and this relative increase continued into May 2002.
A second classic sign of a squeeze is a sudden increase in
the near-term price of a commodity as compared to the price of
the commodity farther in the future (backwardation), while the
markets for other, similar commodities do not exhibit the same
price behavior.\126\ Figure IV-6 shows the difference between
the first and second-month contracts for IPE Brent and NYMEX
WTI futures from July 2000 through August 2002. This chart
shows the two instances in early 2002 in which the near-term
prices for Brent increased sharply, particularly in relation to
the prices for second-month contracts (backwardation), while
the WTI market did not exhibit a similar pattern. The first
instance was due to the large number of Brent cargoes purchased
for shipment to China, and the second instance was due to BP's
acquisition of a large number of Brent cargoes for shipment to
the SPR.\127\ This contrast in the behavior of the Brent and
WTI futures markets is evidence that squeezes in the Brent
market occurred in January and from mid-March to early May
2002.
---------------------------------------------------------------------------
\126\ See Section III.C.
\127\ Although Shell also bought large amounts of Brent in early
2002, the Brent futures market did not show signs of a squeeze from
these purchases, perhaps as a result of Shell's announcement on
February 11, 2002, that it had ``potential demand for all the Brents
[cargoes] in March.'' See The Oil Daily, Another Feared Brent Squeeze
Sends Shock Across Energy, February 13, 2002. Although Shell's
announcement helped spike the Brent spot price to a $1.00 premium over
WTI on February 11, see Figure IV-4, the announcement also may have
discouraged traders from selling futures contracts for delivering
Brent, thereby avoiding a squeeze. See also Section IV.C.
[GRAPHIC] [TIFF OMITTED] T5551.030
The increase in the price of various Brent derivatives in
the OTC markets is additional evidence the Brent market was
squeezed in January and from mid-March to early May.\128\
Figure IV-7 shows, for example, the difference between the
price of the first month IPE Brent futures contract and the
price of dated Brent. This price difference is equivalent to
the price of a DFL swap, which is a Brent derivative traded on
the OTC market. Figure IV-7 shows that in January and April the
price of a Brent futures contract rose to nearly $1.50 more
than the price of a dated Brent cargo, indicating the
``shorts'' holding futures contracts requiring delivery of
Brent were being forced to pay a premium to the ``longs.'' The
monthly pricing patterns for DFL swaps from October 2001
through May 2002, as seen in Figure IV-7, are similar to the
pattern for DFL swaps during the Arcadia squeeze in August
2000, as shown in Figure III-11. An increase in the price of a
DFL swap, by itself, does not indicate a squeeze; however, a
squeeze will result in an increase in the price of a DFL
swap.\129\
---------------------------------------------------------------------------
\128\ See Section III.B. for an explanation of these Brent
derivatives.
\129\ See Horsnell and Mabro, supra, at 130-132, for a discussion
of the effect of a Brent squeeze on these derivatives.
[GRAPHIC] [TIFF OMITTED] T5551.031
The price spikes in the futures and OTC contracts for Brent
in January and throughout April 2002 cannot be explained by
global oil supply and demand. The global economy was in a
slump. The crude oil markets had yet to recover from the drop
in demand following the September 11, 2001 terrorist attack on
the United States. Indeed, the WTI futures market reflected
these fundamentals--that current demand for crude oil was lower
than anticipated future demand, and near-term prices were lower
than prices further in the future (contango). The Brent market,
however, was just the opposite (in backwardation), with higher
near-term prices reflecting the immediate demands on Brent
supplies from China and the SPR, rather than overall global
supply and demand.
In sum, the large number of shipments of Brent sent to the
SPR and China, from November 2001 through May 2002,
significantly increased the price of Brent relative to WTI,
caused the near-term price for Brent to rise relative to the
price of more distant Brent futures contracts (backwardation)
for extended periods, and caused significant price increases in
the OTC market. From mid-March through early May 2002, the
demands placed on the Brent market by the SPR program squeezed
the Brent market.\130\
---------------------------------------------------------------------------
\130\ In interviews with the Subcommittee staff, officials from the
London IPE and the U.K. FSA agreed with the characterization that the
Brent market was squeezed in January and April 2002.
---------------------------------------------------------------------------
3. Higher Brent Prices Increased the Price of Crude Oil Imported
into the United States
Increases in the price of Brent relative to WTI led to
relative increases in the price of a variety of crude oils
priced off Brent. Most of the crude oils priced off Brent are
sold in term contracts that set the price of the oil at a fixed
differential to the price of dated Brent. Generally, these
differentials are fixed for the term of the contract, and are
not renegotiated during the term of the contract. Squeezes and
other disruptions in the Brent market that increase the price
of dated Brent, therefore, generally increase the cost of crude
oil priced off Brent under term contracts. Since term contracts
are individually negotiated and not traded on any exchange,
however, information on the terms of these contracts is
unavailable, and the total impact of Brent price increases
cannot be measured.\131\
---------------------------------------------------------------------------
\131\ On April 24, 2002, the Petroleum Intelligence Weekly, in the
article Beyond Hoarding, wrote, ``Buyers of less transparent or term
contract barrels have been less able to protect themselves from the
spiking benchmark.''
---------------------------------------------------------------------------
Crude oil spot market data, however, provides evidence of
how higher Brent prices increased the price of crude oils
priced in relation to Brent. Although comprehensive and
reliable spot price data is not available, the spot price of
Nigerian Bonny Light, a major crude oil imported into the
United States, is commonly reported by trade publications.
Bonny Light is produced in Nigeria and is usually priced at
a discount to Brent. The price of Bonny Light is generally
reflective of the price of other Nigerian crudes. The United
States imports large amounts of crude oil from Nigeria, which
is the fifth largest exporter of crude oil to the United
States, sending, on average in 2001, about 850,000 barrels
daily to refiners in the United States.\132\ An increase in the
cost of Nigerian imports, therefore, has significant effects
for refiners and consumers in the United States.
---------------------------------------------------------------------------
\132\ See Figure III-3.
---------------------------------------------------------------------------
Data on spot market transactions shows the price of this
Nigerian crude oil closely tracked the price of Brent during
the period examined, from October 2001 through June 2002.
Figure IV-8 shows how the price of Bonny Light moved in tandem
with the price of Brent during this period.
[GRAPHIC] [TIFF OMITTED] T5551.032
Figure IV-9 shows the difference between the price of dated
Brent and the price of Bonny Light over the same time period.
The data shows that the differential between the price of Bonny
Light and the price of dated Brent varied by only a few cents
per barrel from late 2001 through May 2002. This data
demonstrates that as the price of dated Brent rose during this
time period, the price of Bonny Light rose as well.\133\ Hence,
as the price of Brent rose relative to WTI, the price of
Nigerian crude oils rose too.
---------------------------------------------------------------------------
\133\ Due to demand from Asia, Nigeria had little incentive to
discount its crude oil for prospective purchasers in North America. The
narrowing of the Brent/Dubai differential due to OPEC productions cuts
in 2001 led Asian refiners to increase their purchases of Atlantic
Basin sweet crudes, including Nigerian crudes. In light of the
increased Asian demand for west African crudes, most west African
exporters, such as Nigeria, did not provide discounts to refiners in
the United States. According to one press report, ``Most West African
crudes have managed to defend differentials to international benchmark
dated Brent reasonably successfully in a tricky market.'' Energy
Intelligence Briefing, Spring West African Barrels Pointed at US, Not
Asia, April 23, 2002.
[GRAPHIC] [TIFF OMITTED] T5551.033
In sum, the use of so much Brent to fill the SPR was a
major factor increasing not only the price of Brent relative to
WTI, but also the price of other sweet crude oils priced off
Brent. Since both Brent and other crude oils priced off Brent,
like Bonny Light, are regularly exported in large amounts to
the United States, these increases significantly raised the
costs of importing crude oil in the latter months of 2001 and
the first part of 2002.
4. Higher Costs for Imported Crude Oils Led to Fewer Imports
The most immediate effect on the U.S. crude oil market of
the Brent price increases just described was to increase the
relative price of crude oil imports. From November 2001 to May
2002, the price of Brent rose to within 50 cents of WTI on 48
different days, and on 17 days was more expensive than WTI. As
a rule of thumb, it is uneconomical to import Brent or other
Atlantic basin sweet crudes when Brent is priced within about
$1.50 of WTI. Although other factors mattered too, such as
transatlantic shipping rates, grade differentials, and the
price of other U.S. Gulf Coast crudes, like Louisiana Light
Sweet (LLS), the unprecedented magnitude of the increases in
the price of Brent relative to WTI beginning in late 2001 made
Brent imports significantly more expensive when compared to
domestic grades or to oil already purchased and stored in U.S.
commercial inventories.
A number of contemporaneous reports in oil industry trade
publications explain how relatively higher prices for Brent
affected U.S. crude oil imports. For example, several of these
trade press reports state that on a number of occasions during
this period the increases in the price of Brent relative to WTI
``closed the arbitrage.'' On January 14, 2002, Weekly Petroleum
Argus reported that Sempra's acquisition of a large number of
Brent cargoes from BP ``pushed dated Brent to a premium over
WTI, shutting off the arbitrage that allows crude cargoes to
sail from Europe and west Africa to the US.'' \134\
---------------------------------------------------------------------------
\134\ The transaction involved a swap of 60 cargoes, a volume of
oil greater than the entire amount of Brent produced in February.
Weekly Petroleum Argus, Brent Blip Squeezes Transatlantic Traffic,
January 14, 2002.
---------------------------------------------------------------------------
On February 4, Petroleum Argus reported that the January
Brent squeeze, caused by Sempra's shipments of Brent cargoes to
China, had distorted Brent-related trade and cut off shipments
of Brent and other North Sea crudes to the United States.
``Trade on Brent-related crudes, particularly other North Sea
grades, became unhealthily opaque as buyers and sellers
struggled to avoid the price spike. Brent's inflated strength
forced some European refiners to cut runs. And dated Brent
moved to an abnormally wide premium over WTI--from its
customary discount--choking off the flow of cargoes to the
U.S.'' \135\
---------------------------------------------------------------------------
\135\ Petroleum Argus Global Markets, Ending Brent's Eternal Games,
February 4, 2002.
---------------------------------------------------------------------------
Following Shell's announcement that it had enough orders to
purchase all of the Brent cargoes in March, most of which were
deposited into the SPR, the transatlantic trade again was
disrupted. ``North Sea trade came to a standstill as the market
waited for Shell's intentions to become clear, pressuring
unsold late February loading cargoes. . . . The prospect of
another Brent trading play reduced the US appetite for Brent-
linked North Sea and west African crudes.'' \136\
---------------------------------------------------------------------------
\136\ Petroleum Argus Global Markets, Prices Jump on Squeeze Talks,
February 18, 2002.
---------------------------------------------------------------------------
In mid-March, The Oil Daily reported the increase in the
price of Brent relative to WTI had caused a decline in U.S.
imports, putting upward pressure on domestic crude oil prices.
``The narrow arbitrage between WTI and North Sea Brent, of
about 25 [cents] on Friday, has been working against
competition from foreign barrels, contributing to keeping
values for most US grades steady last week.'' \137\
---------------------------------------------------------------------------
\137\ The Oil Daily, US Sweet Grades Firm, Sours Lose Ground While
WTI-Brent Arbitrage Remains Closed, March 18, 2002.
---------------------------------------------------------------------------
In early April, the Financial Times Business Recorder
reported that a brief drop in the price of dated Brent had
opened up the trans-Atlantic trade:
Crude oil traders are scrambling to exploit a brief
opening in the trans-Atlantic arbitrage for European
crude, taking advantage of a fall in benchmark dated
Brent despite steamy futures prices. As much as 10
million barrels of sweet North Sea grades have recently
been booked to sail west in April, fleeing the severely
depressed European market, but the opportunity could be
short-lived if wet Brent climbs again as many traders
expect. \138\
---------------------------------------------------------------------------
\138\ Business Recorder, Never Mind Futures, Europe and US Crude
Arb Opening, April 5, 2002. From mid- to late-March, the Brent-WTI
differential averaged about 90 cents.
Crude oil traders quoted in this article attributed the higher
dated Brent prices choking the transatlantic trade to the
filling of the SPR: `` `The levels are all distorted because
you don't have fundamentals, you have the SPR commitments that
are affecting Dated,' said one trader with a US refiner.''
\139\
---------------------------------------------------------------------------
\139\ Id.
---------------------------------------------------------------------------
In late April, Petroleum Argus reported the April Brent
squeeze was distorting the transatlantic trade.\140\ ``A
squeeze on Atlantic basin benchmark Brent caused the grade's
third price distortion this year, and pushed prices $2/bl
higher last week. This left US benchmark WTI at a 35 cents/bl
discount to Brent in May and confused transatlantic arbitrage
economics. Sellers of Brent-linked North Sea grades were forced
to slash their offers relative to dated Brent to keep cargoes
moving to the US.'' \141\
---------------------------------------------------------------------------
\140\ See Figures IV-6 and IV-7.
\141\ Petroleum Argus Global Markets, Brent Squeeze Wreaks Havoc,
April 22, 2002. The article also noted, ``Advance warning of the Brent
squeeze had been provided by the short-term swaps market for dated
Brent and Brent contracts for differences (CFDs). They indicated a late
April and early May price spike.''
---------------------------------------------------------------------------
Still another trade publication wrote about the decline in
transatlantic Brent trade in late April due to higher prices.
``The victim of a trading squeeze, liquidity in the physical
Brent market had all but dried up and price transparency had
effectively been limited to the often manipulated contract-for-
difference market. . . . A delay in the release of the May
loading program and the lack of transparency as well as the
steeply backwardated dated Brent pricing profile acted as a
brake on trade.'' \142\
---------------------------------------------------------------------------
\142\ Nefte Compass, Crude Oil: Brent Squeeze Hypes Benchmark,
April 23, 2002.
---------------------------------------------------------------------------
U.S. import data over this period shows a striking decline
in imports of North Sea and west African crude oils priced off
Brent. Figure IV-10 shows that this decline in imports began in
December 2001 and continued through April 2002. This time
period corresponds with the period during which the price of
dated Brent rose, on average, 75 cents relative to WTI, and in
which the transatlantic trade was totally disrupted several
times due to the squeezes in the Brent market.
Figure IV-10 also shows that Nigerian crude oil imports
dropped the most of the Atlantic Basin crude oils imported into
the United States during this period. From October 2001 through
February 2002, imports of crude oil from Nigeria declined by 33
percent. In April 2002, imports from Nigeria were 45 percent
lower than in April 2000, and 56 percent lower than in April
2001. This data is consistent with the data in Figures IV-8 and
IV-9 showing the spot price of Nigerian Bonny Light moving in
tandem with the price of dated Brent, thereby become relatively
expensive compared to WTI. During this period the amount of
crude oil from the United Kingdom also dropped significantly
compared to previous U.K. import levels. Not including Brent
crude oil sent to the SPR in April 2002, imports of crude oil
from the United Kingdom were 20 percent lower than in April
2001, and 65 percent lower than in April 2000.
[GRAPHIC] [TIFF OMITTED] T5551.034
Crude oil imports into the United States declined more in
the first half of 2002 than in any of the comparable time
frames over the past several years. Figure IV-11 shows that
from January through March 2002, average daily imports
declined, whereas over a similar 3-month period in the years
1999 through 2001 average daily imports were increasing.
Additionally, average daily U.S. imports in April 2002 were
substantially lower than in April 2001 and April 2000.
The overall level of U.S. imports in early 2002 also was
affected by a general economic slowdown following the September
11 tragedy, so the reduction in imports seen in Figure IV-11
was also caused by a decline in demand. Higher import prices
were nonetheless another major factor contributing to this
reduction.
[GRAPHIC] [TIFF OMITTED] T5551.035
Additional evidence that the level of overall imports was
reduced largely as a result of the reduction in imports priced
off Brent is provided in Figure IV-12, which shows the level of
U.S. imports priced off WTI. From January 2002 through April
2002, at the same time the level of imports priced off Brent
declined by 500,000 to 1 million barrels per day, \143\ no
parallel decline took place in the amount of imports priced off
WTI.
---------------------------------------------------------------------------
\143\ See Figure IV-10.
[GRAPHIC] [TIFF OMITTED] T5551.036
The regional breakdown of U.S. crude oil imports provides
further evidence that reduced imports of Brent-priced sweet
crudes were responsible for the most of the decrease in U.S.
crude oil imports during the first 5 months of 2002. Figures
IV-13, IV-14, and IV-15 provide a month-by-month comparison of
daily import levels into the East Coast (PADD 1), the Midwest
(PADD 2), and the Gulf Coast (PADD 3). Of these three regions,
refiners on the U.S. East Coast were the most sensitive to the
price of Brent, as a number of East Coast refineries rely
heavily on sweet crudes from the United Kingdom, Norway, and
west Africa. Refiners in the Midwest (PADD 2) use both light,
sweet crudes and heavy, sour crudes, and some Midwestern
refiners are able to vary the types of crudes run through the
refinery as the economics of the crude oil and refined product
markets vary. Figures IV-13, IV-14, and IV-15 show that in the
first several months of 2002 the East Coast, which is the
refining region most sensitive to the price of Brent,
experienced the most significant drop in imports, and that
Midwestern refiners, who also rely heavily on light, sweet
crudes, also cut back on imports significantly.
[GRAPHIC] [TIFF OMITTED] T5551.037
[GRAPHIC] [TIFF OMITTED] T5551.038
[GRAPHIC] [TIFF OMITTED] T5551.039
Although a number of other factors also affected the price
and supply of crude oil during the first part of 2002, these
factors did not affect U.S. import levels nearly as much as the
relative increase in the price of Brent during the first 5
months of 2002. For example, although in early April Saddam
Hussein announced a suspension of Iraqi oil exports for 30
days, imports from Iraq did not decline below average levels
until May 2002. As late as April 2002, the United States was
importing over 750,000 barrels per day from Iraq, nearly at the
2001 daily average of 795,000 barrels per day.
Despite growing political unrest and an 8-day strike by oil
workers in Venezuela, imports from Venezuela ranged from 1.1 to
1.25 million barrels per day from January through May 2002,
which is roughly equivalent to the Venezuelan imports over the
same period in 2000, and only slightly less than the 1.29
million barrels per imported daily, on average, in 2001. The
strike spiked the market for several days, but the strike was
short-lived and there were no long-term effects upon U.S.
supplies from the temporary suspension of exports.\144\
---------------------------------------------------------------------------
\144\ See, e.g., Bloomberg News, Oil Prices Fall as End Seen for
Venezuelan Strike, National Post April 23, 2002. Additionally, OPEC
representatives signaled to the market that OPEC would work to
stabilize oil prices if the disruption in Venezuela continued. ``If the
drama in Venezuela continues we could have a problem and we might have
to put more oil on the market,'' one OPEC official stated. U.S.
Secretary of Treasury O'Neill said ``it appeared that Saudi Arabia and
other oil producers were `doing whatever production it takes' to stay
within a price band.'' Matthew Jones and Andy Webb-Vidal, OPEC Moves to
Limit Impact of Venezuela, Iraq, Financial Post, April 11, 2002. See
also Nadim Kawach, UAE Saudi Arabia Assure Oil Supply, Gulf News, March
21, 2002.
Contemporaneous trade press reports also state that the
Venezuelan strike had no effect upon U.S. crude oil producers operating
in Venezuela. Petroleum Finance Week, As Chavez Returns, Venezuela's
Oil Industry Tries to Get Back to Normal, April 22, 2002.
---------------------------------------------------------------------------
Some observers attributed the reduction in U.S. imports in
early 2002 to OPEC production cuts announced in January 2002.
For example, in its weekly report released on April 24, the
DOE's Energy Information Administration (EIA) linked the
reduction in imports to lower OPEC production quotas:
U.S. crude oil imports over the last 4 weeks have
averaged just 8.8 million barrels per day, or nearly
850,000 barrels per day less than over the same period
last year. With OPEC 10 (excluding Iraq) crude oil
production in the first quarter of 2002 averaging 22.6
million barrels per day, this is the lowest quarterly
average since the second quarter of 1992! With less
crude oil being produced by these countries after a
series of cuts in production quotas, they are exporting
less, and so it is no surprise to see the world's
largest importing country experiencing declining
imports.\145\
---------------------------------------------------------------------------
\145\ EIA, This Week in Petroleum, April 24, 2002. In its report
for the previous week, EIA had also stated, ``most of the reason for
the crude oil import deficit rests with OPEC's decision to cut their
quotas by another 1.5 million barrels per day (effective on January 1),
which has clearly reduced imports into the United States.'' EIA, This
Week in Petroleum, April 17, 2002.
EIA monthly data indicates, however, that the OPEC
production cuts were not nearly as significant a factor as
initially reported. Of the 850,000 barrel-per-day reduction
noted in the EIA's April 24 report, reduced imports of Atlantic
Basin sweet crudes priced off Brent accounted for nearly all
this amount--815,000 barrels. Reductions from Nigeria alone
accounted for nearly 630,000 barrels, or about 70 percent, of
this reduction. See Figure IV-10.
Of the Atlantic Basin countries exporting crude oil, only
Nigeria is a member of OPEC. The reason for the large reduction
in Nigerian exports appears not to be the OPEC quotas, but the
relatively high price of Nigerian crude oil priced off dated
Brent. Even with Nigeria's initial adherence to the OPEC
quotas, there was a surplus of Nigerian crude because of its
inflated price and depressed demand. In early March, one
publication reported, ``At this time of the month, most of
Nigeria's crude oil cargoes designated to load in the Apr. 1-10
time frame should have found permanent homes. They haven't. . .
. To be fair, Nigerian barrels are not alone in having
difficulties finding buyers. The physical market is well and
truly in the dumps.'' \146\ Similarly, in early May it was
reported:
---------------------------------------------------------------------------
\146\ Energy Intelligence Briefing, Nigeria Ensures OPEC Compliance
in March and April, March 7, 2002.
The climate for selling Nigerian oil has taken a
severe turn for the worse in recent weeks, judging by
the May loading schedule for Nigeria's eight main crude
systems. The schedule indicates at least 6 May cargoes
still unsold, while appetite for early June remains
lackluster. Some tankers will soon be steaming toward
the U.S. Gulf Coast--port of last resort--in hopes that
conditions will have improved before they arrive. But
current prospects for placing cargoes at the right
price look slim, as crude supplies appear well in
excess of demand in the United States\147\
---------------------------------------------------------------------------
\147\ Energy Intelligence Briefing, Nigerian Crudes Fail to Impress
US Buyers--So Far, May 7, 2002.
EIA's initial analysis did not reflect the extent to which
global demand was sharply lower in early 2002 than in early
2001. ``Even in a period when the Iraqi embargo and Venezuelan
disruption took barrels off the market unexpectedly, demand
fell even faster--by 1.4 percent and 1.5 percent on the year in
March and April, respectively.'' \148\ In March, global
production exceeded global demand by 400,000 barrels per day,
and in April by 700,000 barrels per day.\149\ By contrast, in
April 2001, global production had exceeded demand by only
100,000 barrels per day. With relatively more crude oil
available on the global market in 2002 than 2001, it does not
appear that the OPEC cuts relative to 2001 production levels
were responsible for the reduced levels of imports into the
United States during this period.\150\
---------------------------------------------------------------------------
\148\ The Oil Daily, Supply-Demand Fundamentals Far From Bullish,
May 23, 2002.
\149\ Petroleum Intelligence Weekly, Oil Prices Fly in Face of
Fundamentals, May 22, 2002.
\150\ As discussed in Appendix 3, the OPEC reductions did affect
the price differential between heavy and light crude oils.
---------------------------------------------------------------------------
In short, political events affecting the global crude oil
markets in early 2002 did not create shortages of crude oil
relative to demand during that period. Rather, in light of the
reduced global demand for crude oil, there were ample supplies
of crude oil available for U.S. refiners.
Moreover, the global political factors just described
affected the global supply and demand for crude oil, not just
the North American market. Thus, although these factors
contributed, to some extent, to the overall increase in the
price of crude oil in the first 5 months of 2002, and the
overall amount of oil supplied, none of these factors explains
the dynamics of the crude oil trade between the United States
and the rest of the world during this period. This trade is
driven by the price differentials between the WTI and Brent
benchmarks, rather than absolute price levels or absolute
supply numbers. Global political events do not explain the
divergences between the Brent and WTI markets beginning in late
2001, when the price of Brent rose significantly relative to
WTI. The most significant factor leading to the reduced U.S.
crude oil imports in early 2002, other than the overall decline
in demand, was the reduction in light sweet crude oil imports
priced off Brent due to higher relative Brent prices resulting
from the use of Brent to fill the SPR.
5. High-Priced Imports Led U.S. Refiners to Use Crude Oil in
Existing Inventories
The relatively high cost of Brent-based imports had two
major effects. First, U.S. refiners able to substitute less
expensive WTI-based crudes did so, thereby increasing the
imports of WTI-based crudes. Secondly, U.S. refiners
increasingly relied upon crude oil already in their inventories
to meet demand and build stocks of gasoline in anticipation of
the upcoming seasonal surge in gasoline usage.
In late March, the EIA noted that crude oil imports were
decreasing at the same time U.S. refinery runs were increasing
in anticipation of the late spring and early summer driving
season. ``With crude oil imports last week at the lowest level
in more than a year (partly due to significant fog-related
closures in the Houston Ship Channel) and refinery runs
increasing, last week saw a drop in crude oil stocks (4.5
million barrels) not seen since the week ending October 12,
2001. If crude oil imports continue to remain low, while inputs
into refineries increase, crude oil stocks would continue to
fall.'' \151\
---------------------------------------------------------------------------
\151\ EIA, This Week in Petroleum, March 27, 2002.
---------------------------------------------------------------------------
Even after the fog lifted from the Houston Ship Channel,
U.S. crude oil imports continued to drop while use of crude oil
in U.S. inventories increased. Total U.S. inventories declined
from about 325 million barrels on April 5 to about 319 million
barrels on April 12, and again declined from late April until
mid-May. From April 5 to April 12 Gulf Coast (PADD 3)
inventories also fell, from about 165 million barrels to about
161 million barrels, and Midwest (PADD 2) inventories slipped
from just over 70 million barrels to about 69 million barrels.
6. Decreasing U.S. Inventories Spiked the Price of WTI
In early April, EIA warned of increasing crude oil prices
due to reduced imports and increasing refinery runs:
The level of crude oil imports to supply increasingly
higher refinery output of petroleum products,
particularly gasoline, has become a major concern over
the past several weeks. In order to stave off a repeat
of last year's steep run up in motor gasoline prices,
crude oil supplies will need to be maintained at a rate
that keeps up with anticipated strong demand for
gasoline and other petroleum products as the U.S.
economy recovers from its recent downturn. . . . If the
discrepancy between crude imports and refinery runs
continues to widen as the summer driving season nears,
both crude and product stocks are expected to drop
sharply, pressuring up further gasoline and other
petroleum product prices.\152\
---------------------------------------------------------------------------
\152\ Id., April 3, 2002.
Two weeks later, EIA's weekly report warned: ``So, at a
time when imports are usually increasing to supply increased
refinery production as the gasoline season begins, this year,
crude oil imports are declining. And while crude oil
inventories started this period in much better position than in
the previous 2 years, at this rate, it won't be long until
crude oil inventories become tight once again, thus putting
more pressure on crude oil prices.''
Indeed, in mid-April the crude oil import data released by
EIA and the American Petroleum Institute (API) affected the
market in just the manner forecast. On April 16, 2002, API
released its weekly industry data report showing a drop in U.S.
crude oil inventories for the previous week. Immediately after
the release of this inventory data, the price of the next-month
WTI futures contract on the NYMEX rose about 20 cents per
barrel. Over the next several days the next-month WTI futures
contract continued to rise. A week later, on April 23, the WTI
contract for delivery of crude oil in June (``the June
contract'') became the next-month contract. At the same time,
API and EIA data continued to show a decline in Midwest (PADD
2) inventories. Traditionally, Midwest (PADD 2) aggregate crude
oil inventories have strongly influenced the price of the NYMEX
WTI contract, because they influence the supply and demand
balance for crude oil at the WTI delivery location at Cushing,
Oklahoma. Generally, the WTI market interprets a decline in
PADD 2 inventories as a sign of a shortage of available crude
oil in the region, and hence such a decline will lead to an
increase in the price of WTI.
The WTI market reacted in just this manner in late April.
Just at the time the June WTI contract became the next-month
contract, the price of this contract jumped above the price of
the next month contract (shifting the market from contango to
backwardation), indicating the market believed there was a
near-term shortage in supply. The increase in the near-term WTI
futures price took place at the same time as the April squeeze
in the Brent market was dissipating, lowering the price of the
near-term Brent futures contract (shifting the Brent market
from backwardation to contango). See Figure IV-6.
Many traders viewed the sudden upward shift in the WTI
market in light of the Brent market's move in the opposite
direction as evidence of a squeeze in the WTI market. For
example, on May 8, 2002, Reuters reported:
The premium for U.S. crude oil prices over other
international grades exploded higher on Wednesday as
dwindling supplies in the pivotal Midwest region made
the market more vulnerable to supply squeezes, traders
said. Oil traders said that a market play by oil major
BP was a driving force behind the sudden U.S. price
run-up--just the latest in a series of trading
maneouvers that has distorted prices on both U.S. and
European markets this year.\153\
---------------------------------------------------------------------------
\153\ Reuters, U.S. Crude Rockets as BP Completes Brent Play, May
8, 2002. Another publication stated: ``Market whispers last week
focused on evidence of yet another wet-barrel crude squeeze, knocking
the futures markets out of whack as they used physical trades as a
guide. . . . The smoking gun: The forward price curve for Brent is in
contango, or upward sloping, while the forward curve for West Texas
Intermediate showed a 90 cents backwardation.'' Petroleum Intelligence
Weekly, Marketview: Smoke and Mirrors, May 15, 2002.
In reality, however, there were ample supplies of crude oil
available to Midwestern refiners, indicating the sudden price
increase in the WTI market was not caused by a squeeze. In
interviews with the Subcommittee staff, traders and officials
with a number of companies supplying and purchasing crude oil
stated there were no shortages of crude oil at this time.
According to these traders and officials, ample supplies of
crude oil in the Gulf Coast were available for Gulf Coast and
Midwest refiners, and the crude oil pipelines from the Gulf
Coast to the Midwest were not filled to capacity.
These traders and officials stated that Midwestern
inventories declined not because of any physical shortages of
crude oil, but rather because the imports that were reaching
the Gulf Coast ports were too expensive for Midwestern
refiners. According to traders interviewed by the Subcommittee,
because crude oil priced off Brent arriving at the Gulf Coast
already was expensive compared to WTI, it was uneconomic for
Midwestern refiners to pay the additional costs to transport
the crude oil by pipeline from the Gulf Coast to their
refineries in the Midwest. These traders state they had plenty
of crude oil in the Gulf Coast, and would have sent it to the
Midwest if it were economical to do so.
Instead of buying the relatively expensive imports,
Midwestern refiners used crude oil from their existing
inventories. As a result, Midwestern inventories declined.
Figure IV-16 shows the decline in Midwestern (PADD 2)
inventories during this period. Figure IV-17 shows that during
this same period Gulf Coast supplies were increasing,
indicating the decline in Midwestern inventories was not due to
any shortage of crude oil, but rather because it was not
economical to ship the relatively high-priced imports arriving
on the Gulf Coast up to the Midwest.
[GRAPHIC] [TIFF OMITTED] T5551.040
[GRAPHIC] [TIFF OMITTED] T5551.041
``Refiners do not corroborate the widespread interpretation
that the US Midwest is short of crude, and neither do the
data,'' the Oil Market Intelligence wrote on May 21.\154\ The
article blamed the relatively high near-term prices in the WTI
market on the reluctance of Midwestern refiners to purchase
crude oil: ``They are not keen on buying the incremental barrel
because of the steep premium of prompt delivery to the second
month, and are inclined to run down stocks and hold out for
lower prices.'' \155\
---------------------------------------------------------------------------
\154\ Oil Market Intelligence, Crude Oil Market Tightness: Squeezed
or Perceived?, May 21, 2002.
\155\ Id.
---------------------------------------------------------------------------
Another article in the same publication observed it was
``no surprise'' the ``sharp and sudden backwardation'' in the
WTI market followed ``two weeks of sizable crude draws in the
US. In particular, crude stocks in Padd 2--the Midwest region--
deflated by nearly 5 million barrels between mid-April and mid-
May.'' \156\ The article concluded crude oil traders had
perceived the inventory drops in the Midwest (PADD 2) as an
indication of a crude oil shortage:
---------------------------------------------------------------------------
\156\ Oil Market Intelligence, Feature: Perception vs. Reality, May
21, 2002.
Traders bought the apparent Midwest tightness hook,
line, and sinker, bidding up the front-month price of
WTI by as much as $3 in the second and third week of
May. Crude inventories in Padd 2, some suggest, are
something of a barometer for the shape of the forward
price curve. Indeed, the relationship between the
first- and second-month New York Mercantile Exchange
contracts for light, sweet crude map very closely the
magnitude by which Padd 2 crude stocks rise or fall
above 65 million-67 million [barrels].\157\
---------------------------------------------------------------------------
\157\ Id.
But in fact, the article observes, there was no tightness
---------------------------------------------------------------------------
in the supply of crude oil for the Midwest:
But is the U.S. market really short of crude? At
second glance, the situation in the Midwest looks to be
not so much a story of refiners without crude, as it is
a story of crude without refiners. Refiners deny that
there is any outright lack of availability, the prices
just aren't right. . . . Meanwhile, since the run-up in
the front-month [WTI] crude price, it makes more sense
to rely on term-contracts and crude in storage for
throughputs, than it does to buy up prompt wet barrels.
As evidence, they point to slowed crude supplies from
Canada, and crude pipelines in the Midwest from the U.S. Gulf,
which have ample spare capacity. In fact, crude stocks have
piled up in the U.S. Gulf even faster than they drained from
mid-continent tanks over the last month.\158\
---------------------------------------------------------------------------
\158\ Id.
---------------------------------------------------------------------------
The widely held but inaccurate perception of the actual
supply and demand balance in the United States during the
Midwest (PADD 2) inventory draw-down was re-enforced as
refiners, in response to the sudden increase in near-term
prices, drew even more heavily from their inventories of stored
oil rather than make new purchases. This further drawdown in
stocks further increased the near-term prices in the
backwardated WTI market, creating a vicious cycle of inventory
draws and near-term price increases that continued until the
June NYMEX WTI contract reached expiry. As Oil Market
Intelligence wrote: ``[E]nough market players have interpreted
the stock draws as a shortage in the Midwest that they have
successfully bid up prices. The result: a reinforcing cycle of
backwardation.'' \159\
---------------------------------------------------------------------------
\159\ Id.
---------------------------------------------------------------------------
Figure IV-18 shows the difference between the first and
second month WTI futures contracts for the period from February
through June 2002. This Figure shows the price of the near-
month WTI futures contract jumped immediately after the release
of the API and EIA inventory data. This spike in the near-term
futures price for WTI lasted about 1 month, increasing the WTI
June futures price nearly 20 percent, from $24.75 to $29.36 per
barrel.
From a variety of contemporaneous reports, as well as from
the price data, it appears that the spike in the WTI June
contract price, which lasted from late April through late May,
was caused by traders bidding up the price of the contract in
light of the declining Midwestern oil inventories. In the Gulf
Coast, however, there was an excess of supply over demand, as
indicated by rising inventories. Given this excess of supply
relative to demand, Gulf Coast prices should have fallen and
excess oil should have been shipped to the Midwest. But the
near-month price for WTI continued to increase, discouraging
refiners from buying oil, and causing WTI prices on the NYMEX
to increase even more. Because the WTI contract delivery point
is in the Midwest, it was the declining Midwestern inventories,
rather than the plentiful Gulf Coast inventories, which drove
up the price of WTI nationwide.
This example illustrates how the supply and demand balance
in the Midwest can present an isolated, disproportionate, and
inaccurate reflection of national supply and demand, and yet
still be the most significant factor affecting the NYMEX WTI
price. If, indeed, as Dr. Mabro states, the ``most important
function [of prices] is to signal at every moment the state of
the supply/demand balance,'' over this time period the NYMEX
WTI contract failed in its most important function.
[GRAPHIC] [TIFF OMITTED] T5551.042
Figure IV-19 shows the sharp rise in the price of the near-
month WTI futures contract that began on April 16, when API and
EIA data showing a decline in total U.S. and Midwestern
inventories, and continued through late May, as Midwestern
inventories declined from mid-April through late May (see
Figure IV-16).
[GRAPHIC] [TIFF OMITTED] T5551.043
Figure IV-19 shows that the price of the next-month WTI
futures contract rose from $24.75 per barrel on April 16 to a
peak of $29.36 on May 14, an increase of approximately $4.60,
or 19 percent. Within days of expiry of the June contract, the
WTI near-month futures contract price dropped back down to
around $25, the WTI near-month futures price before the price
spike. The sudden rise in the WTI next-month price as soon as
the June contract began trading and the sudden fall in the
next-month price after the June contract expired indicates the
June contract price was artificially inflated and did not
reflect the fundamentals of global supply and demand.\160\
---------------------------------------------------------------------------
\160\ The price of the WTI nearest-month contract fell about $1 per
barrel per day just before expiry--from $28.33 on May 20 to $27.33 on
May 21 to $26.37 on May 22--and then down to $25.27 on May 28,
following the Memorial Day holiday.
---------------------------------------------------------------------------
Figure IV-20 shows that the WTI spot price closely tracked
the nearest-month WTI futures price during this period. As seen
in this figure, the price spike in the WTI futures market in
April and May spiked the prices in the crude oil spot market as
well.
[GRAPHIC] [TIFF OMITTED] T5551.044
An upper-bound estimate of the additional crude oil costs
imposed by the April-May WTI spike can be obtained by
calculating how much the WTI spot price rose during the spike
compared to the WTI spot price before and after the spike. The
spot price of WTI before and after this spike was about $25 per
barrel. The average price of WTI during the spike, from April
16 to May 21, was $27.16. Hence, the spot price of WTI was, on
average, $2.16 higher during the April-May spike than before or
after. Under this methodology, in just the 1-month period from
April 16 to May 21, U.S. consumers and businesses paid over $1
billion in additional costs for crude oil as a result of the
SPR fill.\161\
---------------------------------------------------------------------------
\161\ The U.S. consumes approximately 18 million barrels of crude
oil each day. $2.16/barrel/day x 30 days x 18 million barrels/day =
$1.17 billion. A similar upper-bound estimate of over $1 billion in
additional costs is reached if one takes the $2 drop in the price of
the near-month WTI futures contract that occurred at the expiry of the
June WTI contract as the added cost attributable to the backwardation
the previous month.
These estimates do not include the additional costs passed on
through OTC instruments linked to the price of WTI. Nor do they include
the additional costs to U.S. consumers and businesses from the increase
in the cost of imports priced off Brent from November through May. This
Report does not quantify these costs because of the unavailability of
specific crude oil price and volume data for the affected imports.
---------------------------------------------------------------------------
A more conservative, lower-bound estimate, of the added
costs imposed on U.S. consumers is obtained by comparing the
first and second month WTI contract prices to determine how
much the first month contract rose above the baseline price
during the 1-month price spike. Generally, the price of the
second-month contract is viewed as a more accurate reflection
of global supply and demand, since it is not subject to the
type of distortions that can affect the price of a first-month
contract near expiry. Thus, under this methodology, the second-
month contract price is considered the ``baseline'' WTI price.
From April 23 to May 21, the price of the first month contract
exceeded the price of the second-month contract by, on average,
60 cents per barrel. Prior to and after these dates the second-
month contract was higher than the first month contract by
about 20 cents. Hence, the first month contract rose, on
average, 80 cents relative to the second month or ``baseline''
price during this period. Under this methodology, in the 1-
month period from April 23 to May 21, U.S. consumers and
businesses paid over $450 million in additional costs for crude
oil as a result of the SPR fill.\162\
---------------------------------------------------------------------------
\162\ $0.80/barrel/day x 30 days x 18 million barrels/day = $432
million. Again, this calculation does not take into account additional
costs arising from inflated costs for OTC instruments or costs arising
from the Brent price increases.
---------------------------------------------------------------------------
It is reasonable to conclude, therefore, that the WTI price
spike in April and May 2002 increased crude oil costs for U.S.
consumers and businesses by between $500 million and $1
billion. Most of these higher costs were passed on to consumers
and businesses in the form of higher costs for home heating
oil, diesel fuel, and jet fuel.\163\
---------------------------------------------------------------------------
\163\ Spot prices are, in effect, wholesale prices. As a general
matter, increases in petroleum product spot prices are eventually
passed on in the form of higher retail prices for consumers. See, e.g.,
Michael Burdette and John Zyren, EIA, Diesel Fuel Price Pass-through,
at EIA website at http://www.eia.doe.gov/pub/oil--gas/petroleum/
feature--articles/2002/diesel.htm1. Because of the decentralized nature
of retail sales for petroleum products, which are sold through tens if
not hundreds of thousands of retail outlets across the nation, retail
sales data is much more difficult to obtain than data for the futures
or spot markets. A host of additional factors affect product markets,
apart from the crude oil markets, making an analysis of the specific
short-term retail effects of increases in crude or wholesale prices
beyond the scope of this Report.
---------------------------------------------------------------------------
7. WTI Price Spike Led to Price Spikes for Home Heating Oil, Jet
Fuel, and Diesel Fuel
Figures IV-21, IV-22, and IV-23 show how the increases in
the WTI spot price increased the price of home heating oil, jet
fuel, and diesel fuel. From April 16 through May 14, the 19-
percent increase in the WTI spot price spiked the spot price
for home heating oil by 13 percent, jet fuel by 10 percent, and
diesel fuel by 8 percent.
[GRAPHIC] [TIFF OMITTED] T5551.045
[GRAPHIC] [TIFF OMITTED] T5551.046
[GRAPHIC] [TIFF OMITTED] T5551.047
8. Higher Home Heating Oil, Jet Fuel, and Diesel Fuel Prices Hurt
U.S. Consumers and Businesses
Increases in the prices of these basic commodities affect
nearly every American and every sector of the economy. Home
heating fuel increases, for example, affect millions of
families and businesses in the Northeast and Midwest. According
to the Department of Energy, 70 percent of homes in the
Northeast rely on home heating oil.\164\ In Michigan, for
example, the percentage is 3.5 percent, in Minnesota, it is 8
percent, and in Maine, 4 out 5 people, or 80 percent, heat
their homes with oil.\165\
---------------------------------------------------------------------------
\164\ http://www.eia.doe.gov/emeu/plugs/plheat.html.
\165\ See, for example, Michigan Public Service Commission website,
at http://cis.state.mi.us/mpsc/reports/energy/02--03winter/distill.htm;
``More Minnesotans heating with natural gas,'' Minnesota Public Radio,
December 4, 2002; ``Agency predicts surge in oil prices; A study finds
Mainers could pay 45 percent more this winter, depending on the chill--
and the winds of war,'' Portland Press Herald, October 15, 2002.
---------------------------------------------------------------------------
The hardships caused by expensive heating fuel have long
been recognized. The Low Income Home Energy Assistance (LIHEAP)
program assists more than 4.6 million low-income households
each year. Recently, LIHEAP has provided about $1.5 billion
each year to assist U.S. households with energy costs related
to extreme heat and cold. At a 2002 event announcing the
release of $200 million in LIHEAP funding for American families
facing rising heating bills, U.S. Secretary of Health and Human
Services Tommy Thompson noted, ``Higher fuel prices pose a real
hardship for many Americans. This emergency aid will give
states the opportunity to help more of their citizens stay warm
this winter.'' \166\
---------------------------------------------------------------------------
\166\ http://www.ncat.org/liheap/news/Jan03/emergen.htm.
---------------------------------------------------------------------------
Congress also recently established the Northeast Heating
Oil Reserve (NHOR) to stabilize home heating oil prices. This
reserve was established to reduce the disruptive effects
associated with home heating fuel shortages and sudden price
hikes, such as occurred in December 1996 and early 2000. NHOR
currently holds about 2 million barrels, all of which were
acquired by exchanging crude oil from the SPR for heating oil
delivered to NHOR storage facilities in New Jersey,
Connecticut, and Rhode Island.
Programs like LIHEAP and NHOR mean that the 13 percent jump
in heating fuel futures caused by the 2002 crude oil price
spikes imposed not only higher costs on U.S. consumers and
businesses in the Northeast and Midwest, but also on taxpayers
across the country, since these government programs are funded
with taxpayer dollars.
Jet fuel is another key petroleum product that was affected
by the 2002 crude oil price increases. Jet fuel is the second
largest airline cost after labor, and, each month, U.S.
airlines consume approximately 1.6 billion gallons of jet
fuel.\167\ In 2002, the airlines were estimated to have
consumed about 18 billion gallons altogether.\168\
---------------------------------------------------------------------------
\167\ ``Higher energy prices so far an irritant, but not a
detriment, to U.S. economy,'' Associated Press, December 20, 2002.
\168\ Information supplied by Air Transport Association.
---------------------------------------------------------------------------
Jet fuel price increases have a major impact on the
airlines' finances and ability to keep operating. David
Swierenga, chief economist at the Air Transport Association,
informed the Subcommittee staff that ``every penny increase per
gallon translates into $180 million in added costs annually . .
. which the beleaguered industry can ill afford.'' \169\
Another economist has estimated that when the price of crude
oil increases by 1 percent, the price of jet fuel increases by
0.74 percent.\170\ One low-cost operator, Southwest Airlines,
indicated that, ``Jet fuel accounts for 15 percent of our cost
structure. When we see energy prices move, it has a very
dramatic effect on us.'' \171\ Another airliner, Northwest
Airlines, has calculated that each penny increase in jet fuel
costs it an additional $20 million annually.\172\
---------------------------------------------------------------------------
\169\ Id. See also testimony of Susan Donofrio, Deutsche Bank
Securities, before the Senate Committee on Commerce, Science, and
Transportation, October 2, 2002.
\170\ Subcommittee interview with Gene Huang, FedEx economist,
February 5, 2003.
\171\ ``Crude awakening,'' San Francisco Chronicle, April 10, 2002.
\172\ ``Rising fuel prices hit NWA,'' Star Tribune, July 6, 2001.
---------------------------------------------------------------------------
Media reports noted that, in 2000, high jet-fuel bills
wreaked havoc on the airline industry, forcing bankruptcy
filings of some start-up carriers, lowering earnings at major
airlines, and widening losses at others.\173\ In 2002, jet fuel
prices increased 10 percent, from about 56 centers per gallon
in January to about 78 cents in December. This added expense
came on top of higher airline safety costs, higher debt levels,
and reduced travel demand after the 9-11 tragedy in 2001. This
added expense contributed to the airlines' ongoing financial
woes, which have persisted even after the industry received a
$5 billion cash infusion authorized by Congress in 2001.
Altogether in 2002, the major U.S. airlines suffered losses
estimated between $5 and $7 billion; increased jet fuel costs
over the same period contributed to these losses.
---------------------------------------------------------------------------
\173\ See, for example, ``Southwest's Fuel Hedging Yields Lower
Prices, Savings,'' Wall Street Journal, January 16, 2001.
---------------------------------------------------------------------------
Diesel fuel, a third key petroleum product, is also
sensitive to crude oil price increases. Due to their
reliability, efficiency, and safety, diesel engines play a key
role in the U.S. economy, powering engines used in agriculture,
construction, mining, transportation, and the military.\174\
The Diesel Technology Forum has determined that locomotives,
ships, trucks, and other forms of transportation utilizing
diesel fuels move 94 percent of the nation's goods and
materials, or more than 18 million tons of freight, each day.
Farm equipment, which is essential to not only the 2 million
operating farms in this country but also millions of consumers
that buy U.S. food, generally relies on diesel fuel. Diesel
fuel also powers most buses, including intercity, transit, and
school buses, and a number of post office vehicles. Overall,
the Diesel Technology Forum calculates that the gross output of
the diesel industry in 1997, the last year for which figures
are available, totaled more than $85 billion.
---------------------------------------------------------------------------
\174\ See ``Diesel Technology and the American Economy,'' a report
prepared for the Diesel Technology Forum, October 2000.
---------------------------------------------------------------------------
The American Trucking Association estimates that for every
dollar increase in crude oil prices, retail diesel fuel prices
increase 2.8 cents.\175\ An economist at FedEx, Gene Huang,
estimates that when the price of crude oil increases by 1
percent, diesel prices increase by 43 percent.\176\ Figure IV-
23 demonstrates how closely diesel prices tracked crude oil
prices in the first part of 2002.
---------------------------------------------------------------------------
\175\ Subcommittee interview with Diego Saltes, economist at the
American Trucking Association, February 3, 2003.
\176\ Subcommittee interview with Gene Huang, FedEx economist,
February 5, 2003.
---------------------------------------------------------------------------
Higher diesel prices hike costs in each of the sectors that
rely on diesel fuel, often with attendant, negative ripple
effects across the U.S. economy. One example is the trucking
industry. Nearly all large trucks that transport freight in the
United States run on diesel fuel, with the trucking industry
consuming roughly 32 billion gallons each year.\177\ According
to the American Trucking Association, the trucking industry
employs almost 10 million people, including over 3 million
drivers, and accounts for nearly 5 percent of U.S. gross
domestic product. Bob Costello, chief economist at the American
Trucking Association, estimates that for every 10 cent increase
in the price of diesel an average 1,000 motor carriers with
five trucks or more in their fleet go bankrupt. According to a
transportation analyst with A.G. Edwards, Donald Broughton, the
large numbers of trucking company failures in 2000 and 2001
generally coincided with the rise in diesel prices.
---------------------------------------------------------------------------
\177\ Information provided to Subcommittee staff.
---------------------------------------------------------------------------
In addition to trucking business failures, trucking
disruptions can impose an immediate, widespread drag on the
U.S. economy by delaying shipment of goods and materials.
``There is more dependence on just-in-time deliveries,'' Mark
Whitenton of the National Association of Manufacturers said.
``Even a couple of days disruption could cause factories to
close.'' \178\ In 2000, for example, a price spike in diesel
fuel stalled truckers in parts of New England. ``Diesel fuel
cost between $2.50 and $2.60 a gallon, and trucks would not
even go into Maine because there was not enough freight to pick
up on the return trip to offset the cost,'' said Todd Spencer
of the Owner-Operator Independent Drivers Association.\179\
After Iraq invaded Kuwait in 1990, and crude oil prices nearly
doubled to $41 per barrel, one long-haul trucker, Lee Klass,
stopped driving.\180\ ``The price of diesel fuel jumped 40
cents a gallon,'' Klass recounted. Rather than pay the price at
the pump, he parked his truck. ``It reaches a point that unless
rates are doubled it doesn't make sense to haul any freight.''
---------------------------------------------------------------------------
\178\ ``Fuel price escalation already spills into cost of other
goods,'' Chicago Tribune, January 26, 2003.
\179\ Id.
\180\ Id.
---------------------------------------------------------------------------
Home heating oil, jet fuel, and diesel fuel prices spiked
in the spring of 2002 as a result of the increase in the price
of crude oil. Since that time, the prices of these petroleum
products have continued to climb along with crude oil prices.
They have been joined by increases in gasoline prices. Since
these and other costs took place after the period examined in
this case study, they are discussed in the next section of this
Report. Their attendant negative effects on the U.S. economy
have continued to hurt U.S. consumers and businesses.
In light of the economic harm to U.S. consumers and
business from higher prices for home heating fuel, jet fuel,
and diesel fuel, as well as other costs associated with high-
priced crude oil, it is critical that DOE recognize these costs
and take steps to minimize the costs associated with depositing
oil into the SPR.
9. High Crude Oil Prices Increased Refinery Costs
Higher crude oil prices in early 2002 also increased
refinery costs. A refiner's income is determined by how much it
can sell its product for on the wholesale market, and its
expenses are determined by how much it has to pay for crude oil
and how much it costs to operate the refinery. If it can sell
its products for more than it costs to purchase the crude oil
plus its expenses, then it will make a profit; if not, it will
lose money. The difference between the price a refiner can
obtain for a refined product, such as gasoline, and the price
of crude oil is called the ``refining margin,'' and to a large
extent determines the profitability of the refinery.
In spring 2002, U.S. refiners saw their crude oil costs
increase significantly, but were unable to raise gasoline
prices due to the high level of gasoline supplies resulting
from a flood of gasoline exports from Europe. Because the
plentiful supplies of excess European gasoline capped potential
increases in the retail price of gasoline, more direct consumer
harm from the crude oil price increases was avoided. Instead,
U.S. refiners absorbed these additional costs.
Because U.S. refiners could not pass along the increased
costs of crude oil to the gasoline market, refining margins
fell significantly in April and May. The overall margin for a
refinery (termed the ``crack spread'') is determined by taking
into account the refining margins for several of the key
products of a typical refinery. Figure IV-24 shows the negative
effect the April-May WTI price spike had on the ``3-2-1 crack
spread.'' The 3-2-1 crack spread is calculated by assuming that
three barrels of crude oil are refined into two barrels of
gasoline and one barrel of heating oil. As Figure IV-24
demonstrates, refining margins, as measured by the 3-2-1 crack
spread, fell from $6.38 per barrel on April 16, when the EIA
and API inventory data was released, to $3.98 per barrel on May
21, when the WTI June contract reached expiry.
The near-40 percent fall in the crack spread resulting from
the WTI price spike dropped this measure of refinery
profitability to one of the lowest levels in the past several
years.
[GRAPHIC] [TIFF OMITTED] T5551.048
These lower refining margins were one of the major reasons
for the dismal financial performance of oil companies in the
second quarter of 2002.\181\ Table IV-1 presents the reported
earnings of major oil companies for the second quarter of 2002,
a very poor quarter for refiners, as compared to the second
quarter of 2001, a very good quarter for refiners.
---------------------------------------------------------------------------
\181\ The narrowing of the heavy-light and sweet-sour differentials
led to major losses for U.S. refiners that rely on heavy and sour
crudes. Although OPEC production cuts are often attributed to be the
reason for the narrowing of this differential in the first half of
2002, the decrease in Atlantic basin sweet crude imports due to high
Brent prices led U.S. refiners to use relatively more heavy sour
crudes. This shift in the relative percentages of heavy and light
imports also contributed to the narrowing of the heavy-light
differential in the second quarter of 2002.
[GRAPHIC] [TIFF OMITTED] T5551.006
Different refiners were affected differently, based upon
the slate of crude oils normally purchased for the different
refineries. East Coast refiners relying on the transatlantic
---------------------------------------------------------------------------
trade in sweet crudes priced off Brent were hit hardest:
Average U.S. gross refining margins dropped more than
$1 barrel to $2.50 a barrel during the week ended May
11, marking the fourth consecutive weekly decline due
to high crude oil prices and relatively moderate prices
for gasoline and distillates, according to Salomon
Smith Barney's weekly margin report. . . . The weakest
margins are on the East Coast for Brent-based
production at $1.40 a barrel, while the highest are in
the Midwest at $4.40 a barrel.\182\
---------------------------------------------------------------------------
\182\ Reuters, US Refining Margins in Red in Most Regions--Report,
May 14, 2002.
The high costs of Brent were cited as reasons for production
cuts at the Valero and Phillips refineries in New Jersey.\183\
---------------------------------------------------------------------------
\183\ Id. In mid-May, Valero announced it would cut back on
refinery production by 23 percent--or by 360,000 barrels per day--as a
result of ``high product inventory levels and uneconomical operating
conditions.'' The Oil Daily, Refiners Put Brakes On As Car Season
Nears, May 17, 2002; Oil Market Intelligence, Americas: Where's the
Upside?, May 21, 2002. ``The very low margin between the selling price
of gasoline and the purchase price of crude oil is the reason for the
run cuts,'' Valero officials stated Dow Jones, Valero Cuts Runs at Non-
West Coast Refineries by 20%, May 16, 2002.
---------------------------------------------------------------------------
The negative effects of the SPR program on refinery
performance is of concern because low refining margins
threatening the financial viability of many U.S. refiners. Low
and volatile refining margins have been one of the main factors
underlying the large degree of consolidation in refinery
ownership that has occurred in recent years. In a number of
areas of the country the refining industry has become highly
concentrated, exacerbating the volatility of gasoline prices,
harming consumers and the national economy.\184\ To the extent
that governmental action imposes additional costs upon this
industrial sector with no attendant benefits, further
investment in this sector is discouraged, energy security is
diminished, and consumers are harmed.
---------------------------------------------------------------------------
\184\ The Subcommitttee's Report, Gasoline Prices: How Are They
Really Set? on page 322 of the PSI hearings held Apr. 30 and May 2,
2002, S. Hrg. 107-509, addressed these issues.
---------------------------------------------------------------------------
Perhaps most significantly, in recent years refiners have
been reducing inventories as a way to reduce costs.
Governmental actions and policies that increase the costs for
refining crude oil, without any commensurate benefits, will
lead refiners to reduce inventories even further.\185\ This
will lead to more price volatility and higher consumer prices.
---------------------------------------------------------------------------
\185\ For example, independent refiner Valero, which was one of the
companies most affected by the increase in crude oil prices and the
narrowing of the heavy/light differential in early 2002, and facing a
downgrade by Moody's credit-rating agency, recently announced that it
had cut its stocks from a high of 69 million barrels in 2002 to 54
million barrels. Philip K. Verleger, Jr., Notes at the Margin, February
3, 2003.
---------------------------------------------------------------------------
C. Oil Company Decisions to Send So Much Brent to the SPR
Although DOE provides SPR contractors with the option to
place a variety of sweet crude oils into the SPR, from the
fourth quarter of 2001 through the second quarter of 2002,
nearly 90 percent of the sweet crude oil deposited into the SPR
was Brent crude oil. The placement of so much Brent crude oil
into the SPR, as well as the shipment of so much Brent to
China, halved the normal Brent-WTI differential for most of
this period and squeezed the Brent market twice, once in
January, and once around April. The Arcadia squeeze of 2000 had
demonstrated the price increases that would follow of a squeeze
in the Brent market, so traders acquiring large amounts of
Brent in 2002 would have known that acquiring large amounts of
Brent would significantly increase prices.
One of the issues examined by this investigation is whether
traders may have acquired large amounts of Brent in early 2002
to create these foreseeable impacts and profit from them, or
whether the decision to acquire large amounts of Brent was
motivated by other commercial interests.\186\ Because of the
complexity of the analysis required, and the unavailability of
information about OTC trading activity, the Subcommittee
Minority staff was unable to reach a conclusion on this matter.
---------------------------------------------------------------------------
\186\ Even if trading activity is undertaken pursuant to a
legitimate commercial purpose, however, a trader's activity still may
amount to abuse under U.K. law or manipulation under U.S. law if the
trader exacerbates a ``natural'' squeeze that has arisen. The CFTC has
warned that traders who continue to purchase ``long'' contracts during
a squeeze may be found to have violated the prohibition against
manipulation. See Appendix 1.
---------------------------------------------------------------------------
The following discussion presents the explanations provided
by oil companies interviewed by the Minority Staff as to why
they acquired large amounts of Brent in late 2001 and early
2002. Because of the voluminous and complex records underlying
these transactions, the Staff did not examine company
documents.
In essence, traders with companies that purchased large
amounts of Brent in early 2002 told the Subcommittee staff that
their purchases of futures contracts for Brent were undertaken
solely for hedging purposes, were limited to the amount of
contracts necessary to accomplish this purpose, and were not
undertaken for the speculative purpose of profiting from rises
in the price of Brent. Similarly, these officials stated that
their use of the 15-day Brent OTC market was for the purposes
of hedging and acquiring Brent cargoes.
Sempra Energy Trading Company officials told the
Subcommittee staff that in November 2001, Chinese refiners
placed large orders for Atlantic Basin sweet crude oil because
the Brent-Dubai differential had narrowed, making it more
economic to purchase Brent and other Brent-based grades than
sour Middle Eastern grades. Sempra officials stated they used
the futures market to hedge the purchase price of the cargoes
it was acquiring, and did not make trades to exacerbate the
squeeze.
Shell officials told the Subcommittee staff that in late
January and early February it received a large number of
inquiries and orders for light sweet crude oil. Shell believed
these orders were placed by oil companies seeking light sweet
crude oil to meet the DOE's SPR fill requirements, and from
other traders who had postponed their purchases of North Sea
crudes until the market had returned to contango following the
backwardation arising from the purchase of Brent for buyers in
Asia. Shell stated that its public statement on February 11
that it had potential orders for all of the Brent crude loading
in March evidences its intent to avoid an exacerbation of the
market congestion, which, Shell admitted, was partially done
for purposes of self-interest, as it was acquiring cargoes
during this period. Shell claimed that its announcement,
despite causing a 1-day price spike in the market, helped
prevent the type of squeezes that occurred in January and April
2002.
BP stated that its schedule for delivering crude oil into
the SPR was set by the DOE pursuant to the requirements of the
exchange program under which BP had previously acquired crude
oil from the SPR, and to meet this schedule it was necessary to
acquire large amounts of Brent crude for loading in April and
May 2002. BP pointed to the fact that in early April it
requested the DOE to permit a deferral of its obligations in
light of the high price of Brent that prevailed at the time as
evidence that it sought to relieve rather than exacerbate the
market congestion resulting from the large demands placed on
the Brent market from the SPR program.
All of the traders interviewed by the Subcommittee staff
stated that Brent was the light sweet crude that was easiest
and most economical to obtain. Some traders stated Brent was
preferable even at a small premium in price to other acceptable
sweet crudes because the price of Brent could be hedged more
precisely and because of the ease of obtaining large amounts of
Brent, both directly from the loading terminal at Sullom Voe
and through trades with other companies.
Officials from the London IPE stated in interviews with the
Subcommittee staff that their review of IPE trading activity in
early 2002, which included a review of trading positions and
discussions with all of the parties involved in significant
trades of Brent, did not detect any violations of exchange
rules by any traders within its jurisdiction. Officials with
the U.K. FSA attributed the unusual movements in the price of
Brent to the dwindling supply of Brent, and did not conclude
there was any market abuse under U.K. law. But IPE officials
also noted that their review of the Brent market encompassed
only trading activity within the IPE's market, and did not
extend to other markets, such as trading on the OTC markets.
The Subcommittee's review did not include a review of OTC
activity, since data on OTC trading activity is not available.
Without information about the OTC positions held by traders,
such as the amount and types of contracts purchased or sold,
the price paid, and the dates of the transactions, it is
impossible to arrive at any conclusion regarding whether or not
the OTC markets were used to exploit the squeezes in the
physical and commodity markets, or whether positions were taken
in the OTC markets that would constitute manipulation or abuse
if undertaken on the futures markets.
V. THE 2002 SPR FILL PROGRAM
``If you decide to have a simple rule for acquiring
SPR oil, the worst one you could possibly pick would be
filling at a constant rate of speed.''
--Internal DOE Analysis of SPR Program
``As to the questions that relate to the deferring of
the filling of the Reserve because of issues that
relate to price, we believe it's in our interest at
this point to continue moving ahead at the pace we're
moving to continue filling the Reserve, and not to
defer that because of price fluctuations.''
--U.S. Secretary of Energy, April 9, 2002
In November 2001, the President directed the Secretary of
Energy to fill the SPR to its 700 million barrel capacity ``in
a deliberate and cost-effective manner.'' Existing DOE market-
based practices were to acquire crude oil for the SPR while oil
prices were relatively low and less oil when prices were
relatively high. Pursuant to this market-based policy, DOE had
routinely allowed oil companies to defer scheduled shipments to
the SPR when prices were high in return for additional barrels
of crude oil deposited into the SPR at a later time. This
approach had allowed DOE to avoid disrupting the crude oil
markets and the economy while filling the SPR.
In February 2002, DOE decided to stop allowing SPR
deferrals. Under the new policy, oil was to be put into the SPR
at a constant rate, regardless of the price of oil. Documents
provided to the Subcommittee by DOE indicate the decision to
overturn the SPR program's market-based fill procedures was
made by the Secretary of Energy after consulting with other
high-ranking Administration and White House officials.
DOE documents show SPR career officials opposed discarding
the market-based procedures they had been using to fill the SPR
and then pushed for a return to those procedures. SPR officials
accurately warned about the negative consequences of the no-
deferral policy, including higher prices for crude oil, a
dampening of economic growth, and foregone savings of hundreds
of millions of taxpayer dollars. SPR career officials also
accurately projected that filling the SPR without regard to
global supplies or crude oil prices would reduce U.S. private
sector inventories of crude oil, thereby undercutting the
fundamental purpose of the SPR program--to ensure this nation
has adequate supplies of crude oil in the event of a major
disruption in oil supplies.
A. DOE Changed SPR Policy to Require SPR Fills Regardless of Oil Prices
In February 2002, BP, an oil company, asked DOE for
permission to defer delivery of 9 million barrels of Brent
crude oil that BP was contractually required to deliver to the
SPR in May, June, and July 2002. At the time of BP's request,
SPR Business Procedures allowed deferrals of scheduled deposits
into the SPR provided the company seeking the deferral
compensated the government for the delay by depositing
additional amounts of oil into the SPR at a later time.\187\
SPR policies allowed the SPR Office to ``let the markets
determine [its] buying pattern'' and to use its crude oil
acquisition strategy ``to stabilize markets.'' \188\
---------------------------------------------------------------------------
\187\ See Section II and Appendix 3, Exhibit II-1, for a copy of
the published procedures.
\188\ See Section II and Appendix 3, Exhibit II-2.
---------------------------------------------------------------------------
As explained in Section IV, in early 2002 Brent crude oil
was in scarce supply due to large numbers of shipments of Brent
to China and the SPR. As a result of the increased demand for
Brent, Brent prices had increased in the spot and futures
markets, and the difference in price between Brent and WTI had
narrowed to about 75 cents, a level at which it generally is
uneconomic to ship crude oil across the Atlantic. According to
BP officials, BP was concerned that taking additional large
quantities of Brent out of the marketplace at that time would
further strain Brent supplies and increase prices, and so
requested DOE to defer delivery of the 9 million barrels of
Brent BP was required to deposit in the SPR. DOE denied the
request.
On March 18, 2002, as the near-month price of Brent climbed
to $25 a barrel and near-term prices on the Brent futures
market exceeded future prices (shifting the market into
backwardation), BP renewed its request for a deferral. In an e-
mail to a DOE SPR official, Exhibit V-1, a BP official offered
to deliver an additional 500,000 barrels if DOE would allow a
1-year deferral. In the e-mail, the BP official stated the
deferral would ``eas[e] logistical issues,'' and wondered
``whether the politicians might be keen given the rise in
prices that we are currently seeing.''
In reviewing the BP offer, another SPR official wrote in an
internal e-mail dated March 20, Exhibit V-1, ``See no change in
the no deferral policy unless the price of oil increases.
Recommend saying thank you, but not at the present time.'' On
March 20, William C. (``Hoot'') Gibson, the DOE Project Manager
at the SPR site in Louisiana, responded to BP by e-mail,
stating that DOE wanted to proceed with filling the SPR, and
that BP should deliver according to the terms of the
contract.\189\
---------------------------------------------------------------------------
\189\ This e-mail was described in a telephone conversation between
DOE and Subcommittee staff on November 20, 2002, but DOE has not
provided the Subcommittee with a copy.
---------------------------------------------------------------------------
The next day, March 21, 2002, a DOE official, in an
internal e-mail sent to other SPR officials, Exhibit V-2, wrote
that John Shages, Director of the Finance and Policy Office in
the SPR program, planned to discuss the no-deferral policy with
the staff of the National Security Council, so the issue should
not be considered ``totally closed.'' According to this e-mail:
Deferrals in general were discussed in our PR
[Petroleum Reserves] staff meeting this morning, with
Hoot in attendance. John Shages said he wanted to
discuss with the National Security Council to make sure
he understood what the White House's reaction would be
if prices were to go up to the politically sensitive
level of $30/bbl or so. I think the issue is not
totally closed and will be discussed further by
management.
On April 1, following an increase in the near-month Brent
price to nearly $27 per barrel, BP again asked DOE to allow a
deferral, and upped its offer by another 250,000 barrels. ``I
know that you said last week that the government would have no
interest in deferring the exchange barrels,'' the BP official
wrote in Exhibit V-3, ``but the oil price does keep rising. As
of this morning we calculate a years deferral would be worth an
extra 750,000 [barrels] to you. I'm not trying to bug you on
this, but just wanted to make sure you knew of the
opportunity.''
DOE officials told the Subcommittee staff that ``issue
papers'' discussing BP's deferral request were provided to the
Secretary of Energy as well as to National Security Council
(NSC) and National Economic Council (NEC) officials at the
White House. These DOE officials also told the Subcommittee
staff it was their belief--although they did not have actual
knowledge of the decision process--that the decision to adopt a
no-deferral policy was then made by the Secretary of Energy in
consultation with other high-ranking White House and
Administration officials.\190\
---------------------------------------------------------------------------
\190\ Telephone conversations with Subcommittee staff, November 7,
15, and 20, 2002. In a letter dated December 9, 2002, the Subcommittee
asked DOE to provide all documents generated after November 2001,
related to deferrals of SPR deliveries. On January 10, 2003, DOE
provided several hundred pages of responsive documents to the
Subcommittee, but also stated, ``Certain additional documents still are
under review.'' DOE staff subsequently told Subcommittee staff no
responsive documents containing communications between DOE and the
Executive Office of the President would be provided. DOE has yet to
provide the Subcommittee with copies of documents indicating they were
prepared for the Energy Secretary, NSC, or NEC officials related to the
SPR deferral issue.
---------------------------------------------------------------------------
The no-deferral policy was publicly announced by the
Secretary of Energy at a press briefing on April 9, 2002. This
press briefing took place a few hours after a meeting of
several Cabinet members, including the Secretary of Energy, at
the White House.\191\ A reporter asked the Secretary, ``In
light of Venezuela and Iraq, how serious are you about using
the Strategic Petroleum Reserve or, maybe to a lesser extent,
deferring royalty oil?'' The Secretary responded:
---------------------------------------------------------------------------
\191\ Telephone conversations with Subcommittee staff, November 7,
15, and 20, 2002.
Well, in terms of a decision to tap the Strategic
Petroleum Reserve, I think the President has made it
very clear that that happens if there's a belief that
it's in the national security interests of this
country. We're not at the point of making a--even
looking at those options at this point. It's obviously,
however, a tool available to the President should he
conclude national security interests are involved.
As to the questions that relate to the deferring of
the filling of the Reserve because of issues that
relate to price, we believe it's in our interest at
this point to continue moving ahead at the pace we're
moving to continue filling the Reserve, and not to
defer that because of price fluctuations.\192\
---------------------------------------------------------------------------
\192\ Federal News Service, April 9, 2002.
After the Secretary's public statement on the deferral
policy, a senior SPR career official prepared an internal SPR
document entitled, ``Options for Filling the SPR,'' Exhibit V-
4, which describes the change in the SPR fill policy. This
document notes that the no-deferral decision was made ``after
conferring with the White House'' and that the ``reasoning''
was ``not made public.'' The author observes, however, that
``the most plausible explanation'' is to fill the SPR as fast
as possible ``for national security or energy security
---------------------------------------------------------------------------
reasons.'' One passage states:
Prior to the events of September 11, 2001, the SPR
Office routinely renegotiated delivery dates. The
business model of trading more delivery time for
increased volumes of oil was characterized by reduced
costs, conformance with normal private sector
practices, logistical flexibility to accommodate busy
terminals or maintenance requirements at the sites, and
acceptance by all of the companies with contracts. In
February 2002, the SPR Office received a request to
defer deliveries of 9 million barrels of oil for a
year. The initial offer of extra oil in consideration
of the deferral was valued at $18 million. In order to
stay in conformance with the President's highest
priorities, the SPR Office asked the Administration for
guidance prior to negotiating for this deferral, and
the Secretary after conferring with the White House
announced we were planning to take oil deliveries on
schedule without deferrals. The reasoning for turning
away from a successful business model was not made
public, however, the most plausible explanation is a
desire to have as much oil in the SPR as fast as
possible for national security or energy security
reasons.
Two internal DOE e-mails, Exhibits V-5 and V-6, provide
more evidence that SPR deferral issues were discussed by senior
Administration officials to resolve conflicting views on
whether to postpone SPR oil shipments when crude oil prices
were high. These e-mails indicate that the Department of
Interior (DOI), which oversees the exchange of royalty oil from
federally-owned offshore leases for crude oil to be deposited
into the SPR, wanted to stop transferring oil to the SPR
program ``when a certain trigger price for oil is reached''
such as $30 per barrel.\193\ According to these e-mails, the
DOI and DOE positions differed on whether transfers of oil to
the SPR should stop when the trigger price was reached, and the
issue was to be resolved by the Deputy Secretary of Interior
and the Deputy Secretary of Energy, ``and then reviewed by the
White House.''
---------------------------------------------------------------------------
\193\ See Section II.C.2 for a description of the role of the DOI
in filling the SPR program. As explained in this section, the higher
the price at which royalty oil is used for the SPR program, the greater
the loss to the Treasury from royalty revenues, and hence the greater
the total program cost to the taxpayer.
---------------------------------------------------------------------------
Exhibit V-5, an e-mail dated November 15, 2001, from John
Shages, of the SPR Office, to Deputy Secretary of Energy
Francis Blake, states:
Frank: We held a meeting today with the Minerals
Management Service hierarchy today. They allowed
[Deputy Secretary of Interior] Steve Griles gave them
clear instructions that if oil prices spike, and it
becomes desirable to stop filling the SPR, the MMS
should stop the transfer of royalty oil to DOE. We made
the case for continuing the transfer and allowing DOE
to manage the delivery schedule to eliminate the
unwanted demand. They immediately said the issue would
have to be resolved by you and Steve Griles, and then
reviewed by the White House. They proposed writing an
issue paper for you and Steve Griles, and then reviewed
by the White House. They proposed writing an issue
paper for you and Steve Griles, and we have agreed to
do that jointly with them. While we believe the pros
and cons of this issue are obvious, MMS feels they need
some time to prepare their position and asked for
November 28 as a date to have the paper ready for
delivery to you, and we also agreed to that.
Although both e-mails indicate a joint DOI-DOE issue paper was
being prepared to help resolve this interagency dispute, DOE
informed the Subcommittee staff that the dispute was resolved
in DOE's favor after oral discussions and no such document was
ever prepared.
Together, these internal DOE documents indicate that DOE's
decision to deny BP deferral requests were made after the
Secretary of Energy consulted with other senior Administration
and White House officials. DOE has declined to provide the
Subcommittee, however, any documents prepared by SPR or other
DOE staff for the Secretary of Energy, other top DOE officials,
DOI, NSC, NEC, or other officials in the White House related to
the deferral decision. DOE officials have also provided limited
and, at times, inconsistent information on the process by which
the Energy Secretary made the decision to deny the BP deferral
requests and, more generally, to overturn the SPR Office's
market-based deferral policy in favor of an inflexible rule
against deferrals.
B. SPR Career Officials Opposed Policy Change and Warned DOE the New
Policy Would Increase Oil Prices, Consumer and
Taxpayer Costs
In response to the Subcommittee's request for documents
related to the change in SPR deferral policy, several issue
papers were provided from the files of SPR officials. These
documents provide candid assessments by SPR career officials of
the new no-deferral policy and record their repeated attempts
to return to a market-based deferral policy.
Exhibit V-7 is an internal SPR memorandum analyzing
possible fill rates for the SPR. It notes that DOE has ``the
option of entertaining offers to delay [SPR] deliveries in
return for bonus barrels of oil which could relieve the
speculative oil market,'' as well as options to further
accelerate the fill rate. The undated memorandum appears to
have been written for higher-ranking Administration officials
evaluating BP's April 1 request for a deferral, since it
states, ``DOE has received an offer to pay an additional
750,000 barrels of oil in exchange for rescheduling 9 million
barrels to one year later,'' and discusses the pros and cons of
accepting the offer.
The document summarizes the previous deferral policy of the
SPR Office as follows: ``During 2000 and 2001, whenever these
conditions arose, the SPR Office agreed to later delivery dates
in exchange for more oil. Renegotiation of delivery dates, if
proposed by contractors, in exchange for more oil is the
standard business practice for SPR oil acquisition.'' The
document notes that deferrals during these years enabled DOE to
acquire 7 million barrels of additional SPR oil at no cost,
thereby saving the Treasury $175 million.\194\
---------------------------------------------------------------------------
\194\ See Section II.
---------------------------------------------------------------------------
The document provides an overview of the economic, energy
security, budgetary, foreign relations, and market consequences
of accelerating or deferring shipments to the SPR. The document
summarizes the pros and cons of deferrals as follows:
Option 1: Do not entertain offers to renegotiate delivery dates
Pros
Sends no signals to producing countries or allies
Fills the SPR at an even rate between now and 2005
Does not raise any speculation that the Administration is
willing to meddle in the market
Cons
Deviates from the normal SPR business practice
SPR fill would continue even if markets become distressed
or highly speculative
Option 2: Renegotiate delivery dates
Pros
Reduces the program cost to Treasury, with a potential in
the hundreds of millions of dollars
Acts automatically to counteract market volatility by
increasing demand when prices are relatively low and reducing demand
when prices are relatively high
Acts to mitigate an unwelcome price rise while the
world's economies are only beginning to recover from recession
Could be viewed favorably by consumers
Cons
Delays the addition of oil to the SPR, with energy
security implications
May appear to be a market intervention or an attempt to
challenge OPEC in controlling market inventories and prices
Could be viewed as an accommodation to ``big oil''
The memorandum favors granting deferrals, identifying as
potential benefits, among others, the saving of hundreds of
millions of dollars for the Federal Government and lowering
``unwelcome'' crude oil price increases to benefit consumers
and national economies.
A second document, Exhibit V-4, described earlier, was
prepared after the Secretary of Energy's announcement on April
9, 2002, of the new no-deferral policy. This document describes
how the policy to allow deferrals was overturned by the
Secretary after conferring with the White House, warns of the
adverse consequences of a no-deferral policy, and proposes a
return to the previous policy allowing market-based deferrals,
which the paper calls ``a successful business model.''
According to this document, one of the prime reasons
provided to the SPR Office for not granting deferrals was ``the
concern that the Government should not manipulate the market.''
Countering this assertion, the paper explains in detail how
``its normal business practice does not manipulate the market,
but instead conforms with the goal [that] the acquisition
should minimize impact on market forces.'' Indeed, the paper
notes, ``The simple rule of taking SPR oil as it is
contractually due exaggerates [price swings caused by OPEC
production], since the SPR takes the same volume regardless of
price. It is a business model different from all private market
participants, and if followed by a significant number of market
participants would lead to explosive prices swings.''
The paper advocates a return to acting in ``a rational
business-like manner'':
The SPR Office proposes a return to the SPR oil
acquisition business model, allowing deferrals which
will always be counter-cyclical to OPEC induced price
volatility. Since there would be consistency in our
behavior, markets would not be surprised, and
contractors would be comfortable knowing that the
Government was acting in a rational business-like
manner. Acquiring less oil in high price markets and
more oil in low price markets is . . . ordinary
behavior, [and] it would have much less impact on
market forces than does the practice of ignoring price
and acquiring just as much oil at high prices as at low
prices.
The document also identifies a number of benefits from
allowing deferrals when market prices are high. The document
notes, ``it would be good public policy if oil acquisition were
to take [place] during robust growth and deferred when the
economy is in a cyclical downturn.'' Identified benefits
include reduced costs of oil imports, an improved balance of
trade, and reduced costs for the SPR program.\195\
---------------------------------------------------------------------------
\195\ The final page of this document describing the benefits of
the SPR's prior deferral policy ends in mid-sentence, one-third of the
way down the page. Despite repeated requests, DOE has yet to explain
the missing or redacted information.
---------------------------------------------------------------------------
Another document, Exhibit V-8, is entitled ``Renegotiation
of Delivery Dates for Strategic Petroleum Reserve Oil'' and
contains a handwritten notation ``5/2/2002'' in the upper-right
hand corner. It is a one-page document that, again, advocates
``allow[ing] the [SPR] Office to resume negotiations of
delivery dates for oil that is contracted for delivery on
certain future dates.'' According to this document, the
advantages to allowing renegotiation of delivery dates are that
it is ``very business like''; it ``increases the inventory of
the Reserve without fiscal expense''; the practice ``testifies
to serious management by bringing down the average cost of oil
in the Reserve''; and it is ``good public policy'' because
deliveries ``can be successively renegotiated until [private
sector] inventories are normal, near-term prices are low and
the economy is growing strongly.'' The author observes,
``Insisting on deliveries to the SPR during [a] tight market
would be heavily criticized as mismanagement and would be
difficult to defend.''
Exhibit V-9 is a June 5, 2002, memorandum from John Shages,
a senior SPR official, to Paul Leiby of the Oak Ridge National
Laboratory (ORNL), \196\ in response to an earlier memorandum
sent by Mr. Leiby in May 2002, Exhibit V-10, on designing a
study of the economic impacts of filling the SPR. In his
memorandum, Mr. Shages argues that a policy of allowing
deferrals of deliveries into the SPR based on market conditions
can provide a variety of significant benefits, including lower
overall market prices for crude oil, an improvement in the
balance of trade by $250 million per month, and greater amounts
of crude oil available for private sector inventories.
---------------------------------------------------------------------------
\196\ Mr. Leiby is the principal author of a report prepared for
the SPR Office in November 2000, entitled ``The Value of Expanding the
U.S. Strategic Petroleum Reserve,'' and has authored several other ORNL
reports on the SPR.
---------------------------------------------------------------------------
In one passage, the document states the new no-deferral
policy ``appears irrational to the market place.'' The document
observes that this new policy--which is termed the ``status
quo''--may have facilitated the squeeze in the Brent market in
April 2002:
For 2 years, any contractor could look at the
backwardation in the futures market, and make us an
offer for deferral. We ran our own valuation of the
delay, set a negotiating target for ourselves for a
share of the money on the table, and if we hit our
target we agreed to the deferral. Every contractor
deferred deliveries; they understood the process, it
mimicked what they do in the private sector, and no
surprises. The status quo is what appears irrational to
the market place. It leaves the contractor vulnerable
to things such as a short squeeze in the Brent market,
and in fact there have been some attempts to blame a
recent squeeze in the dated Brent market on us for
demanding delivery regardless of market circumstances.
Also, remember Howard Borgstrom's thesis. It can be
boiled down to, ``If you decide to have a simple rule
for acquiring SPR oil, the worst one you could possibly
pick would be filling at a constant rate of speed.''
In another passage, the document describes the no-deferral
policy as ``a fill model that was discredited years ago.''
Together, these DOE documents demonstrate that SPR career
officials were aware of and warned against the negative
consequences of a strict no-deferral policy, from encouraging
``explosive price swings,'' to increasing taxpayer and consumer
costs, to increasing the market's vulnerability to squeezes.
The documents also demonstrate SPR officials advocated
returning to a flexible deferral policy based on market
conditions and overall national energy security.
C. SPR Career Officials Warned DOE the New Policy Would Reduce U.S.
Crude Oil Commercial Inventories
Exhibit V-4, the internal SPR memorandum prepared by a
career SPR official, also accurately warned DOE that filling
the SPR during a tight market would reduce U.S. private sector
crude oil inventories.
This prediction is based on fundamental market principles
of supply and demand. In a tight market--when immediate demand
is high relative to supply--every barrel of oil that goes into
the government's inventory is at least one less barrel for
private sector inventories. When near-term prices are high
relative to future prices (i.e., when the market is in
backwardation), refiners are more likely to take oil from their
existing stocks than pay for expensive spot market purchases of
crude oil.\197\ When the U.S. Government increases its own
crude oil inventories during a tight market, it further
tightens the market--reducing supplies and raising prices--
making it even more uneconomic for the private sector to
increase commercial inventories.\198\
---------------------------------------------------------------------------
\197\ See, for example, Section IV of this Report, showing how
refiners in the Midwest drew upon their crude oil inventories during
the spike in near-term WTI prices in April and May 2002.
\198\ It has been suggested that each barrel placed into the SPR
during a tight market in preparation for an imminent interruption in
supply may displace more than one barrel in private sector inventories.
Not only is each barrel placed into the SPR one less barrel for use in
the private sector, either in a refinery or in storage, but to the
extent that producers and refiners know the SPR will be available, they
may be less likely to stockpile themselves. For example, one analyst
recently commented, ``Why were the oil companies holding such huge
inventories prior to the Persian Gulf War? You saw a similar buildup
prior to the Iran-Iraq war. And why aren't they building them now? . .
. [I]t could be that they are relying on the U.S. Strategic Petroleum
Reserve, and counting on the government to hold the extra supply for
them.'' Melita Marie Garza, Fuel Price Escalation Already Spills Into
Cost of Other Goods, Chicago Tribune, January 26, 2003, quoting Bill
O'Grady, vice president, futures research, A.G. Edwards.
---------------------------------------------------------------------------
Although the daily fill rate of the SPR is relatively small
compared to daily global consumption and production rates for
crude oil, it is sufficient to remove several millions of
barrels of crude oil from the market over the course of a few
weeks. In a tight market, this marginal reduction in market
supplies can cause a corresponding reduction of several million
barrels of crude oil from private sector inventories. SPR
career officials were well aware of this causal relationship.
Exhibit V-4 explains:
Essentially, if the SPR inventory grows, and OPEC
does not accommodate that growth by exporting more oil,
the increase comes at the expense of commercial
inventories. Most analysts agree that oil prices are
directly correlated with inventories, and a drop of 20
million barrels over a 6-month period can substantially
increase prices. . . . A variation of 3 or 4 million
barrels from expected inventory can change prices more
than a dollar per barrel during a day. Clearly, a
change in private inventories equal to the SPR
inventory change could have a substantial price impact.
In a June 5, 2002, memorandum, Exhibit V-9, John Shages
predicted the SPR fills would significantly reduce private
sector crude oil inventories:
Given OPEC behavior over the last 18 months, I
believe OPEC is not accommodating economic growth, much
less an inventory drop caused by SPR fill. . . . If you
accept the assumption of an intransigent OPEC, then the
impact of SPR fill on inventories is not a seemingly
innocuous 100,000 barrels per day, but a powerful 30
million barrel reduction of private inventory over 10
months.
Later in the June 5 memo, Mr. Shages discusses the SPR's
impact on U.S. inventories as follows: ``Think of the deferrals
not as a daily flow, but as a change to projected inventory in
the private sector. If, come December 2002, U.S. private
inventories are down 30 million barrels of crude oil, we will
have higher prices, nervous traders, a more confident OPEC and
an [Iraq] that can cause price gyrations by deciding not to
renew its export agreements for a month.''
Mr. Shages accurately forecast the decline in U.S. private
sector inventories in the latter half of 2002. Figure V-1 shows
that, from June to October 2002, U.S. commercial crude oil
inventories fell by nearly 50 million barrels, including 1-
month drops of 20 million barrels in July and 30 million
barrels in September. These large drops in inventories followed
price spikes in the WTI market in which near-term crude oil
prices exceeded longer-term futures prices (backwardation). By
February 2003, U.S. private sector inventories had declined to
their lowest levels since the EIA began keeping national
inventory data records in 1979.
Not only have U.S. private sector inventories declined to
unprecedented low levels, but these levels have become
dangerously low--dipping under 270 million barrels which is
considered the ``Lower Operational Inventory'' for the U.S.
refining industry. According to the EIA, ``While there is
nothing to prevent inventories from falling below 270 million
barrels, were that to occur, less flexibility would be
expected, and according to the National Petroleum Council,
localized disruptions in refinery operations could be
expected.'' \199\ U.S. commercial inventories have hovered
around the Lower Operational Inventory Level from the latter
part of 2002 to the present, risking refinery disruptions due
to inadequate supplies.
---------------------------------------------------------------------------
\199\ EIA, This Week in Petroleum, January 15, 2003.
[GRAPHIC] [TIFF OMITTED] T5551.049
Over the same time period, DOE continued to fill the SPR at
a steady rate of about 100,000 barrels per day, or about 3
million barrels per month, regardless of the tightening market
conditions. The total amount of oil deposited into the SPR from
June through November exceeded 20 million barrels.
Figure V-2 shows both the increasing deposits into the SPR
and the decline in U.S. crude oil commercial inventories during
2002. Figure V-2 also shows the periods in which the WTI market
was in backwardation during 2002. When the market is
backwardated, the near-term price of crude oil is higher than
the price of oil farther in the future. Under these market
conditions, refiners will use oil in their existing inventories
rather than purchase expensive oil on the spot market. Placing
oil into the SPR when near-term prices are relatively high
therefore exacerbates the tightness of the market, pushing
near-term prices even higher, and providing incentives for
refiners to take oil out of inventory. Thus, as can be seen
from Figure V-2, depositing oil into the SPR during a tight
market has the direct effect of depleting private sector
inventories.
[GRAPHIC] [TIFF OMITTED] T5551.050
According to the fundamentals of supply and demand,
reductions in crude oil inventories place upward pressure on
crude oil prices. By comparing Figure V-1 and Figure V-3, it
can be seen that at the same time total inventories dropped
from over 320 million barrels at the end of May to just over
270 million barrels by the beginning of October, the spot price
of WTI rose from just under $25 to nearly $31 per barrel. This
relationship between inventory and price is a typical pattern
in commodity markets, and was also predicted by SPR career
officials in the spring of 2002, in Exhibits V-4, V-7, and V-9.
As demonstrated in the case study in Section IV, placing oil
into the SPR in a tight market can trigger a vicious cycle of
lower inventories and higher prices.
[GRAPHIC] [TIFF OMITTED] T5551.051
Despite rising oil prices, tight markets, and shrinking
commercial inventories throughout the latter half of 2002, DOE
kept the SPR no-deferral policy in place. Figure V-4 shows how
the SPR continued to fill at a constant rate from October 2001,
through the first 9 months of 2002, the period for which the
Subcommittee staff obtained detailed SPR program data.
[GRAPHIC] [TIFF OMITTED] T5551.052
The inflexibility of the DOE's no-deferral policy was
demonstrated in late September and early October 2002 when DOE
insisted upon crude oil deliveries to the SPR even as Gulf
Coast refineries were hit by supply disruptions and shut down
due to tropical storms battering the Gulf Coast.
In advance of Tropical Storm Isidore in late September,
nearly 600 offshore oil and gas rigs in the Gulf of Mexico were
evacuated, shutting down 95 percent of crude oil production in
the Gulf. Most of the evacuated workers did not return or had
to be re-evacuated the next week in advance of Hurricane
Lili.\200\ In just over 1 week Isidore and Lili together halted
the production of about 10 million barrels of crude oil from
offshore platforms.\201\
---------------------------------------------------------------------------
\200\ See John Sullivan, Double Hit for Oil Industry, Daily
Advertiser (Lafayette, Louisiana), September 26, 2002; Marc Dupee,
Market Eyes Wrath of Hurricane Lili, October 3, 2002.
\201\ John Sullivan, Double Hit for Oil Industry, infra; Business
Wire, Lili Hits Offshore Hard; Platforms Register 150 mph Winds, 30-
foot Swells, October 4, 2002. Lili was a Category 2 hurricane over
Louisiana, but a Category 4 hurricane when it passed over much of the
oil and gas production area of the Gulf of Mexico. One company measured
150 mile per hour winds at its production platform; another company
reported that its semisubmersible drilling unit had been ripped from
its moorings and blown 45 miles away before grounding in 35-foot deep
water off the Louisiana coast. Id.
---------------------------------------------------------------------------
On October 2, 2002, with Hurricane Lili ``bearing down'' on
its Louisiana refinery, its crude oil supplies depleted due to
the disruption from Tropical Storm Isidore, its Ohio and
Kentucky refineries running at reduced levels due depleted
stocks and crude oil market shortages, and with near-term crude
oil prices over $30 per barrel in the backwardated WTI futures
market, Marathon Ashland Petroleum (MAP) requested DOE to defer
its delivery of 250,000 barrels to the SPR scheduled for
October ``in hopes that we can prolong or at least expedite the
recommencement of refining operations.'' \202\
---------------------------------------------------------------------------
\202\ See e-mails exchanged between MAP and the SPR Office in
Exhibit V-11.
---------------------------------------------------------------------------
DOE denied MAP's request. In an e-mail dated October 7,
2002, Hoot Gibson, the DOE SPR site manager, wrote to other DOE
SPR staff: ``The SPR policy per [the Deputy Assistant Secretary
in the SPR Office at DOE headquarters] on deferrals of in bound
crude oil is no deferrals at this time--deliveries should be
made per current contract dates. Let me know by e-mail each
deferral request received. Any media inquiries should be
referred to Ms Rochon who will refer them to the proper contact
in HQ. Thank you.'' On October 10, DOE informed MAP ``the SPR
is not considering deferrals at the time.''
This decision demonstrates DOE was so determined to
increase the oil stored in the SRP that it was even willing to
risk prolonging refinery slowdowns. Even after being warned by
a major U.S. refiner that it lacked enough crude oil to keep
its refineries running, DOE insisted that the refiner divert
scarce crude oil to the SPR.
The crude oil market deteriorated even further in the last
2 months of the year. The prospect of war between the United
States and Iraq, a major global supplier that provides 5-10
percent of U.S. oil imports, increased market uncertainty
regarding future crude oil supplies and prices. In early
December, Venezuela, a major exporter of crude oil to the
United States, began reducing exports to the United States due
to labor strikes and political unrest. The coldest U.S. winter
in recent years also increased demand for home heating oil,
further tightening the crude oil markets.
By mid-December 2002, several more refiners warned DOE that
the shortage of crude oil imports from Venezuela would lead to
refinery outages and requested a deferral of their upcoming
shipments to the SPR. Initially, DOE denied these
requests.\203\ Instead, DOE declared the Venezuela strike a
``force majeur'' event under the SPR delivery contracts, which
would allow a company to defer delivery if it could prove that
the oil scheduled for delivery into the SPR had been Venezuelan
crude and the company did not have adequate inventories to meet
its SPR delivery requirements.\204\
---------------------------------------------------------------------------
\203\ Cathy Landry, Sheela Ponnusamy, US DOE Rejects Requests to
Defer SPR Deliveries on Venezuela Strike, Platt's Oilgram News,
December 13, 2002.
\204\ Id.
---------------------------------------------------------------------------
Several days later, however, DOE agreed to allow any
company to defer shipments scheduled for December 2002 or
January 2003, even without such proof.\205\ These were the
first SPR deferrals granted in more than a year. According to a
public statement by the Secretary of Energy, this change in
policy was made to ``help ensure that the deliveries will not
negatively affect the oil market, while still providing for the
energy security of the US.'' \206\ The result of this decision
was that 7.8 million barrels scheduled for delivery in December
and January became eligible for deferral.\207\ Nearly all of
these scheduled deliveries were, in fact, deferred.
---------------------------------------------------------------------------
\205\ Cathy Landry, US in Negotiations to Defer SPR Oil Deliveries,
supra note.
\206\ Id. This article quoted a DOE spokesman as saying the
Secretary made the decision ``following consultation with advisors and
oil company analysts.'' DOE has not provided the Subcommittee with any
documentation related to this decision.
\207\ Dow Jones Newswire, December 17, 2002.
---------------------------------------------------------------------------
As the Venezuelan strike continued into 2003, and war
tensions intensified, inventories remained near record lows,
just above the ``Lower Operational Inventory'' level, and crude
oil prices continued to mount. In early January 2003, DOE
announced that deliveries then scheduled for February 2003--
approximately 3 million barrels--were also eligible for
deferral.\208\
---------------------------------------------------------------------------
\208\ Oil Daily, DOE Delays SPR Deliveries, January 6, 2003.
---------------------------------------------------------------------------
On January 24, 2003, Senator Levin called on the
Administration to suspend further SPR deposits ``until surging
crude oil prices stabilize and consumers get relief from rising
prices for gasoline, home heating oil, and other petroleum
products.'' \209\ Specifically, Senator Levin requested
deferral of 4.4 million barrels scheduled to be delivered in
March 2003, and of 3.7 million barrels scheduled to be
delivered in April 2003.
---------------------------------------------------------------------------
\209\ See Sen. Levin Press Release, Exhibit V-12.
---------------------------------------------------------------------------
On January 28, 2003, DOE approved requests from oil
companies to delay the 4.4 million barrels scheduled for March
delivery, but did not, at that time, delay the deliveries
scheduled for April.\210\
---------------------------------------------------------------------------
\210\ Oil Daily, DOE Defers SPR Deliveries, January 28, 2003.
---------------------------------------------------------------------------
One week after granting the deferrals of the March 2003
shipments--presumably to calm crude oil markets--DOE seemed to
reverse course again, announcing a further acceleration of
shipments into the SPR, beginning in April 2003. The new DOE
schedule called for the deposit of an additional 24 million
barrels over 6 months. In total, DOE now plans to deposit about
40 million barrels of crude oil into the SPR in 2003.\211\ If
carried out under current market conditions, these 2003 SPR
deliveries will further reduce commercial supplies, further
help drive up oil prices, and impose more costs upon U.S.
consumers and businesses, again without ensuring any overall
increase in U.S. oil supplies.
---------------------------------------------------------------------------
\211\ The current schedule of SPR deliveries appears in Section
II.C.2.
---------------------------------------------------------------------------
Since abandoning its market-based strategy for deferring
SPR deliveries when crude oil prices are high and supplies
tight, the SPR program has failed to develop a consistent,
coherent, or cost-effective deferral policy. The last-minute
nature of the deferrals granted last December and January, the
delay in making a decision on the April deliveries, and the
further acceleration of shipments into the SPR in the face of
record low inventories and high oil prices, demonstrate that
DOE has yet to embrace a market-based policy.
D. SPR Documents State Filling the SPR Without Regard to Oil Prices
Was Not Justified Even If A Major Supply Disruption
Were Imminent
The SPR career official who wrote Exhibit V-4, on options
for filling the SPR, states that the SPR Office believes it
should not matter to the United States government whether the
crude oil then scheduled for delivery to the SPR in 2002 is
actually delivered in 2002 or postponed to 2003, even if an
``energy supply emergency'' were likely to occur within the
next year. The reasoning underlying this advice is begun but
interrupted in the version of this document provided to the
Subcommittee. Exhibit V-4 states:
The Issue of Urgency to Fill
As noted above the strongest argument against
renegotiating delivery schedules is that there is
urgency to fill the Reserve to its capacity. However,
given the current outlook for OPEC exports, and
commercial inventories, it appears to the SPR Office
the Government should be indifferent to deliveries of
the outstanding oil accounts receivable in 2002 or
2003. If in fact, a major event is likely to occur
within the next year that will cause an energy supply
emergency, it is arguably superior to have the
At this point the document ends in mid-sentence, leaving the
rest of the page blank.\212\
---------------------------------------------------------------------------
\212\ See footnote 195, infra.
---------------------------------------------------------------------------
A clue as to the SPR Office's reasoning, however, is
provided in Exhibit V-9, Mr. Shages's June 2002 memorandum to
Mr. Leiby. In Exhibit V-9, Mr. Shages discusses the costs and
benefits of postponing SPR deliveries scheduled for 2002 until
2003. In this memo, Mr. Shages states there is almost no
incremental benefit to the SPR from placing an additional 42
million barrels, on top of the 570 million barrels already in
the SPR, in 2002 rather than 2003, even if it were known there
would be a massive supply disruption in January 2003. The
document states:
The volume subject to deferrals at this moment is 42
million barrels, and the period of deferral might be a
year. If you ran the [model] and postponed the
incremental fill by 1 year (made 2002 fill equal to
zero but increased 2003 fill by the same volume) how
would the value of the Reserve change? I venture to say
almost not at all, because the chances of drawing all
the oil in the Reserve during the year delay are
minute. Furthermore, if I knew we were going to have a
massive disruption starting in January 2003, given my
assumption that OPEC does not accommodate SPR fill with
more production, I would doubly insist on deferral
because I would rather see a build in private
inventories than in SPR inventories.
Thus, in the opinion of this SPR expert, if the United States
were facing the prospect of a massive and imminent disruption
of oil supplies, U.S. energy security would be better served by
building up oil supplies in private sector inventories rather
than shifting that oil from the private sector to the SPR.
E. 2002 SPR Fills Increased Consumer Costs But Not U.S. Oil Supplies
As predicted by DOE SPR officials, filling the SPR without
regard to oil prices and tight market supplies helped push up
oil prices and deplete U.S. private sector inventories. The
case study in Section IV traces how SPR deposits in the spring
of 2002 raised the prices of crude oil and related petroleum
products, in particular home heating oil, jet fuel, and diesel
fuel. Since then, prices for crude oil have continued to climb,
recently reaching a peak of nearly $40 per barrel. Home heating
oil, jet fuel, and diesel fuel prices have also continued to
climb, and gasoline has recently done so as well. Figure V-5
shows that gasoline prices are now over $2 per gallon in many
markets, record highs for late winter. The continuing record
low levels of crude oil in U.S. commercial inventories may lead
to additional gasoline price spikes as refiners begin to build
gasoline supplies for the spring and early summer driving
seasons. The SPR program's record in 2002 demonstrates that,
under these market conditions, more deposits of crude oil into
the SPR will only exacerbate supply shortfalls and high prices.
[GRAPHIC] [TIFF OMITTED] T5551.053
Despite its high cost to U.S. consumers and taxpayers,
inventory data indicates that the new SPR fill policy did not
increase overall U.S. oil supplies. In 2002, the SPR program
put about 40 million barrels of crude oil into the SPR,
increasing the total reserves by about 7 percent, from about
560 million to 600 million barrels.\213\ Most of this oil was
removed from the marketplace, however, when crude oil markets
were tight, which increased oil prices and caused U.S. oil
refiners to take oil from inventory instead of buying expensive
new oil. In 2002, U.S. commercial inventories dropped 10
percent, from about 310 to 280 million barrels. In 2003,
commercial inventories dropped again to less than 270 million
barrels, dipping below the recognized level at which refinery
operations risk disruptions due to inadequate oil
supplies.\214\ Today, overall oil supplies in the United
States, which consist of the oil in the SPR and commercial
inventories, total about 870 million, the same amount as at the
end of 2001, before the recent SPR fills. Although the SPR
program has placed more oil under government control, lower
private sector oil inventories mean there has been no net
increase in overall national oil supplies.
---------------------------------------------------------------------------
\213\ See Figure II-2.
\214\ See Figure V-1.
---------------------------------------------------------------------------
The benefit to U.S. energy security of shifting oil from
private sector control to government control in the SPR,
without a net increase in overall oil supplies, is unclear at
best, since in the event of a major supply disruption, the SPR
would act to release oil on the market, shifting supplies back
to the private sector.
Filling the SPR to capacity is intended to strengthen U.S.
protections against the ``adverse economic impact'' of a major
oil shortage. But the facts show that the abandonment of the
SPR program's ``deliberate'' and ``cost-effective'' market-
based approach to filling the SPR, in favor of a market-blind
policy of filling the SPR regardless of oil prices, resulted in
the depletion of private sector crude oil inventories by at
least as much as it has increased governmental reserves,
costing U.S. consumers billions of dollars while contributing
marginally, if at all, to overall U.S. energy security.
With crude oil prices at a 12-year high, and U.S.
commercial crude oil inventories at record lows, it is time for
DOE to reassess and revise its policy regarding deferrals of
crude oil shipments to the SPR.
APPENDIX 1
----------
PREVENTING MANIPULATION IN COMMODITY MARKETS
``The methods and techniques of manipulation are
limited only by the ingenuity of man.''
--Cargill v. Hardin, 452 F.2d 1154, 1162 (8th Cir.
1971).
``Sophisticated economic justification for the
distinctions made in this area of law may at times seem
questionable. Sometimes the `know it when you see it'
test may appear most useful.''
--Frey v. CFTC, 931 F.2d 1171, 1175 (7th Cir.
1991).
Summary: Manipulation in commodity futures markets is
effectively prevented only by a comprehensive oversight
program to detect manipulation and an enforcement
program to punish manipulation. Because it is so
difficult to bring an after-the-fact prosecution for
manipulation, it is vitally important to have an
effective market oversight program to detect, deter,
and prevent manipulations before they occur.
I. OVERVIEW
As Appendix 2 explains, a central purpose of the Commodity
Exchange Act (CEA) is to prevent manipulation of the futures
markets. To accomplish this objective, the CEA not only
contains a provision that makes manipulation a felony, but it
also requires approved contract markets to self-regulate to
ensure orderly trading and prevent manipulation. It also
directs a Federal agency--the Commodities Futures Trading
Commission (CFTC)--to oversee operation of the approved markets
and to itself perform market oversight and take necessary
measures to ensure orderly trading and prevent manipulation.
Former CFTC Chairman James Stone explained, ``The job of
preventing price distortion is performed today by regulatory
and self-regulatory rules operating before the fact and by
threats of private lawsuits and disciplinary proceedings after
the fact. Both elements are essential.'' \1\
---------------------------------------------------------------------------
\1\ In the Matter of Indiana Farm Bureau Cooperative Ass'n, Inc.,
1982 CFTC LEXIS 25, 72 (Stone, dissenting), Comm. Fut. L. Rep. (CCH)
para. 21,796 ['82-'84 Transfer Binder] (CFTC Dec. 17, 1982).
---------------------------------------------------------------------------
Congress, the courts, the CFTC, commodity traders, and
legal scholars have struggled with the meaning of the term
``manipulation'' for as long as the law has prohibited it.
Nowhere in the CEA as currently written or any of its
predecessors is the term ``manipulation'' defined. The current
body of judicial and administrative case law is confusing and
contradictory. Not surprisingly, there is widespread
dissatisfaction with the law of manipulation as it currently
stands.\2\ A common theme of this criticism is that the CFTC
and judicial precedents make it too difficult to determine just
what activity constitutes a ``manipulation'' or to prove, after
the fact, that a manipulation has occurred.
---------------------------------------------------------------------------
\2\ See, e.g., Jeffrey Williams, Manipulation on Trial, at 8 (1995)
(``Manipulation is a particularly vague offense.''); In re Soy Bean
Futures Litig., 892 F. Supp. 1025, 1043 (N.D. Ill. 1995) (``[T]here is
a `dearth of settled caselaw' on price manipulation; as a result the
courts and the CFTC are still struggling to define the basic elements
of the claim and to differentiate between fair means and foul in
futures trading.''); Perdue, Manipulation of Futures Markets:
Redefining the Offense, 56 Fordham L. Rev. 345, 401 (1987) (``Congress,
courts, and commentators have condemned manipulation for over 65 years.
Despite this long history, manipulation never has been adequately
defined.''); Friedman, Stalking the Squeeze: Understanding Commodities
Market Manipulation, 89 Mich. L. Rev. 30, 31 (1990) (``Congress has
been intent on preventing manipulation since the beginning of Federal
commodities regulation in the 1920's, yet courts, administrators, and
academic commentators have failed to agree on a sensible approach to
the basic question: What is manipulation?''); Markham, supra at 283
(``[U]nder present law the crime of manipulation is virtually
unprosecutable, and remedies for those injured by price manipulation
are difficult to obtain. Moreover, even where a prosecution is
successful, the investigation and effort necessary to bring a case will
involve years of work, enormous expenditures, as well as an extended
trial.''); Lower, Disruptions of the Futures Market: A Comment on
Dealing with Market Manipulation, 8 Yale J. on Reg. 391, 392 (1991)
(``The absence of a clear statutory definition, the elusiveness of the
economic concepts involved and the ad hoc nature of the enforcement
process has produced a regulatory approach which lacks the clarity and
predictability which would allow effective monitoring, early detection
and successful prosecution.''); Fischel and Ross, Should the Law
Prohibit ``Manipulation'' in Financial Markets?, 105 Harv. L. Rev. 503,
606 (1991) (``Notwithstanding the recent focus on manipulation,
however, no satisfactory definition of the term exists. . . . As one
commentator has noted, `the law governing manipulations has become an
embarassment--confusing, contradictory, complex, and unsophisticated.'
''), quoting McDermott, Defining Manipulation in Commodity Futures
Trading: The Futures ``Squeeze,'' 74 NW. U. L. Rev. 202, 205 (1979);
Pirrong, Commodity Market Manipulation Law: A (Very) Critical Analysis
and a Proposed Alternative, 51 Wash & Lee L. Rev 945 (1994) (``Evidence
abounds that commodity market manipulation law in the United States is
extraordinarily confused.''); Kozinn, Note: The Great Copper Caper: Is
Market Manipulation Really a Problem in the Wake of the Sumitomo
Debacle, 69 Fordham L. Rev. 243, 248 (2000) (``[A]ny student of
commodity manipulation law will discover a body of law that is `a murky
miasma of questionable analysis and unclear effect.' ''), citing
Timothy J. Snider, 2 Regulation of the Commodities Futures and Options
Markets, 12.01, at 12-5 (2d ed. 1995).
---------------------------------------------------------------------------
The difficulties in prosecuting manipulation after-the-
fact, outlined in this Appendix, highlight the importance of
prospective safeguards in the regulatory system. Former CFTC
Chairman James Stone wrote: ``The Act envisions a careful
balance between preventative regulation and remedial judicial
action. To weaken the latter . . . would strengthen the need
for the former.'' \3\
---------------------------------------------------------------------------
\3\ In the Matter of Indiana Farm Bureau Cooperative Ass'n, Inc.,
supra at 74-5 (Stone, dissenting).
---------------------------------------------------------------------------
II. THE LAW OF MANIPULATION
A. Anti-Manipulation Prohibition in Commodity Exchange Act
Section 9 of the CEA states makes it a felony punishable by
a fine of up to $1 million or imprisonment for up to 5 years
for ``Any person to manipulate or attempt to manipulate the
price of any commodity in interstate commerce, or for future
delivery on or subject to the rules of any registered entity,
or to corner or attempt to corner any such commodity.'' \4\
---------------------------------------------------------------------------
\4\ 7 U.S.C.A. Sec. 13(a)(2) (West Supp. 2002).
---------------------------------------------------------------------------
Although this is one of the core provisions of the Act,
nowhere in the statute or the CFTC's regulations is the term
``manipulation'' defined. Moreover, the CFTC, its predecessor
agencies, and the courts have not been able to arrive at a
satisfactory or stable definition of the term. Current case law
provides contradictory guidance on the types of market behavior
that are considered manipulation.
Much of the confusion is inherent in the concept of
manipulation. It is extraordinarily difficult--some would say
impossible--to formulate a test that will easily or
consistently distinguish between legitimate self-interested
market behavior and illegitimate and unfair tactics motivated
by greed. As far back as the 1920's, during the consideration
of the Future Trading Act, which eventually became the Grain
Futures Act and later the CEA, Congress recognized the
difficulty in drawing the line between legitimate and
illegitimate trading. Senator Norris, Chairman of the Senate
Committee on Agriculture and Forestry, stated: ``[T]hese things
are various and perhaps impossible of direct definition. I do
not know how we would draw a definition to bring it home to the
individual.'' \5\ Shortly after the Grain Futures Act was
passed, the Grain Futures Administration reported to Congress
that ``it is practically impossible, merely because a man
sells, to prove that he is doing it in order to manipulate the
market.'' \6\ Tommy ``the Cork'' Corcoran, President Franklin
Roosevelt's legendary lobbyist, once stated with respect to
securities manipulation, ``you cannot tell at exactly what
stage a kitten becomes a cat in determining whether a man
bought or sold on the market for the purpose of raising or
depressing the price.'' \7\ Another practical reason for
failing to specify the elements of the offense of manipulation
``arose from [Congress's] concern that clever manipulators
would be able to evade any legislated list of proscribed
actions or elements of such a claim.'' \8\ To date, no-one has
been able to establish a `` `smoking-gun,' conduct-based test''
for manipulation.\9\
---------------------------------------------------------------------------
\5\ Future Trading in Grain, Hearings on H.R. 5676, before the
Senate Committee on Agriculture and Forestry, 67th Cong., 1st Sess. 335
(1921); cited in Perdue, Manipulation of Futures Markets: Redefining
the Offense, 56 Fordham L. Rev. 345, 353, n. 64.
\6\ Commodity Short Selling, Hearings before the House Committee on
Agriculture, 72nd Cong., 1st Sess. 181 (1932); cited in Markham, supra
at 312.
\7\ Stock Exchange Practices, Hearings before the Senate Committee
on Banking and Currency on S. Res. 84, 56, and 97, pt. 15, 73rd Cong.,
1st Sess. 6509 (1934); cited in Markham, supra at 366, n. 548.
\8\ In re Soy Bean Futures Litig., supra at 1044.
\9\ Pirrong, supra at 992.
---------------------------------------------------------------------------
Because of the sparse legislative history of the term
``manipulation,'' the CFTC and the courts have often relied
upon Arthur Marsh's testimony in 1928 before the Senate
Agriculture Committee in interpreting what Congress meant by
the term.\10\ Marsh, a former President of the New York Cotton
Exchange, had accused another witness, William Clayton, of
manipulating the cotton market in New York, and in so doing
provided the following definition of manipulation:
---------------------------------------------------------------------------
\10\ See, e.g., Volkart Brothers, Inc. v. Freeman, 311 F.2d 52, 58
(5th Cir. 1962).
Manipulation, Mr. Chairman, is any and every
operation or transaction or practice, the purpose of
which is not primarily to facilitate the movement of
the commodity at prices freely responsive to the forces
of supply and demand; but, on the contrary, is
calculated to produce a price distortion of any kind in
any market either in itself or in its relation to other
markets. If a firm is engaged in manipulation it will
be found using devices by which the prices of contracts
for some one month in some one market may be higher
than they would be if only the forces of supply and
demand were operative; or using devices by means of
which the price or prices of some month or months in a
given market may be made lower than they would be if
they were freely responsive to the forces of supply and
demand. Any and every operation, transaction, device,
employed to produce those abnormalities of price
relationship in the futures markets, is
manipulation.\11\
---------------------------------------------------------------------------
\11\ Cotton Prices, Hearings before a Subcommittee of the Senate
Committee on Agriculture and Forestry, Pursuant to S. Res. 142, 70th
Cong., 1st Sess. 201-202; cited in Perdue, supra at 362.
Clayton denied all accusations of manipulation and
complained about the vagueness of the charge. In response to a
Senator's question, Clayton remarked, ``The word
``manipulation'' . . . in its use is so broad as to include any
operation of the cotton market that does not suit the gentleman
who is speaking at the moment.'' \12\
---------------------------------------------------------------------------
\12\ Id. at 154; cited in Perdue at 355, n. 67.
---------------------------------------------------------------------------
Several of the elements of manipulation identified by Marsh
have become part of the basic test used by Federal courts and
the CFTC in determining whether manipulation has occurred. They
include: (1) whether the market prices reflect actual
conditions of supply and demand or whether the prevailing
prices were artificially created by the suspected manipulator;
(2) whether the suspected manipulator caused the artificial
price; and (3) whether the suspected manipulator intended to
cause the artificial price.
In Cargill v. Hardin, the U.S. Court of Appeals for the
Eighth Circuit provided the most recent Federal appellate
exposition on the meaning of ``manipulation.'' \13\ Cargill had
been charged with manipulating the wheat futures market by
controlling nearly two-thirds of the long futures contracts
just prior to the close of trading, as well as most of the
physical deliverable supply of wheat. The court distinguished
between what are perhaps the two most common types of
manipulation, a ``corner'' and a ``squeeze.'' With respect to a
corner, the court stated:
---------------------------------------------------------------------------
\13\ Cargill v. Hardin, 452 F.2d 1154 (8th Cir. 1971).
In its most extreme form, a corner amounts to nearly
a monopoly of a cash commodity, coupled with the
ownership of long futures contracts in excess of the
amount of that commodity, so that shorts--who because
of the monopoly cannot obtain the cash commodity to
deliver on their contracts--are forced to offset their
contract with the long at a price which he dictates,
which of course is as high as he can prudently make
it.\14\
---------------------------------------------------------------------------
\14\ Id. at 1162.
The court identified a ``squeeze'' as ``a less extreme
---------------------------------------------------------------------------
situation than a corner,'' in which:
There may not be an actual monopoly of the cash
commodity itself, but for one reason or another
deliverable supplies of the commodity in the delivery
month are low, while the open interest on the futures
market is considerably in excess of the deliverable
supplies. Hence, as a practical matter, most of the
shorts cannot satisfy their contracts by delivery of
the commodity, and therefore must bid against each
other and force the price of the future up in order to
offset their contracts.\15\
---------------------------------------------------------------------------
\15\ Id. The Cargill court noted that not all squeezes are caused
by intentional manipulations, but may also result from ``natural market
forces,'' such as natural disasters that destroy the supplies of the
commodity. The court cautioned that a person who finds himself with
supplies in such circumstances does not have a license to extract as
high a price as possible:
[G]iven a shortage of deliverable supplies for whatever
reason, the futures prices can be manipulated by an intentional squeeze
where a long acquires contracts substantially in excess of the
deliverable supply and so dominates the futures market--i.e., has
substantial control of the major portion of the contract--that he can
force the shorts to pay his dictated and artificially high prices in
order to settle their contracts.
---------------------------------------------------------------------------
In Cargill, the court adopted the following test:
We think the test of manipulation must largely be a
practical one, if the purpose of the Commodity Exchange
Act is to be accomplished. The methods and techniques
of manipulation are limited only by the ingenuity of
man. The aim must be therefore to discover whether
conduct has been intentionally engaged in which has
resulted in a price which does not reflect basic forces
of supply and demand.\16\
---------------------------------------------------------------------------
\16\ Cargill v. Hardin, 452 F.2d at 1163.
Relying upon the various judicial precedents, the CFTC has
established a four-part inquiry to determine whether
manipulation has occurred. In a 1989 decision, In the Matter of
Cox and Frey,\17\ the CFTC stated that in order to sustain a
charge of manipulation, the CFTC must demonstrate, by a
preponderance of the evidence, that:
---------------------------------------------------------------------------
\17\ 1987 Westlaw 106879 (C.F.T.C.)
(1) the accused had the ability to influence market
prices;
(2) the accused specifically intended to do so;
(3) artificial prices existed; and
(4) the accused caused the artificial prices.\18\
---------------------------------------------------------------------------
\18\ Id.
A review of the judicial and CFTC caselaw indicates that
establishing each of these elements is an extraordinarily
difficult task.
1. Market Power
The first factor, the ability to influence market prices,
requires a determination of whether the person accused of
manipulation of the price of a commodity had sufficient market
power to affect the market price of the commodity, and whether
alternative supplies of the commodity were reasonably available
to market participants. The two parts of this factor are inter-
related and often dissolve into disputes over the appropriate
scope of the market to be analyzed.
Federal courts have disagreed over which facts are
sufficient to establish market power, the scope of available
substitute commodities, and the obligation of commodity traders
to purchase such substitutes. In Great Western Food
Distributors v. Brannan,\19\ for example, Great Western Foods
was accused of manipulating the price of refrigerated eggs by
obtaining possession and control of the supply of deliverable,
refrigerated eggs in the Chicago area as well as ownership of
between 60 and 75 percent of the open long futures contracts in
the week before the futures contract expired. Under these
circumstances, the open short contracts were required to bid up
the price of the scarce remaining supplies of eggs in the
Chicago area in order to avoid default on their contracts for
delivery. In addition to finding that Great Western Foods
dominated the physical supply of refrigerated eggs in the
Chicago area, the court found that fresh eggs ``customarily
range higher in price than refrigerators,'' and therefore
``were generally not contemplated as part of the supply for
these futures transactions.'' \20\ The court found that ``out
of town prices plus freight and differential charges render out
of town eggs more costly for delivery on Chicago contracts than
local eggs,'' and therefore there was ample justification for
the conclusion that Great Western Foods ``held a controlling
position in the available cash supply of eggs deliverable on
December futures contracts.'' \21\
---------------------------------------------------------------------------
\19\ Great Western Food Distributors, Inc. v. Brannan, 201 F.2d 476
(7th Cir. 1953).
\20\ Id. at 480.
\21\ Id. at 481.
---------------------------------------------------------------------------
In another case involving the availability of substitutable
supplies, Volkart Brothers v. Freeman,\22\ the Fifth Circuit
Court of Appeals reached a contradictory result. Under the
futures contract at issue in this case, only certificated
cotton could satisfy the contract delivery requirement.
Nevertheless, the court held that the supply of cotton that had
not yet been certificated prior to the last day of trading must
be considered as part of the available supply of certificated
cotton where a party stands accused of squeezing the contract
for certificated cotton on the last day of trading. The court
wrote, ``Unless the shorts are to be excused from the
performance of their contracts and from the exercise in due
diligence to that end, the ample supply of uncertificated
cotton must be considered as available to them.'' \23\ In light
of the availability of uncertificated cotton, the court
overturned the agency's finding of manipulation of the price of
certificated cotton.
---------------------------------------------------------------------------
\22\ Volkart Brothers v. Freeman, 311 F.2d 52 (5th Cir 1962).
\23\ Id. at 60.
---------------------------------------------------------------------------
In Cargill v. Hardin,\24\ the Eighth Circuit rejected the
Fifth Circuit's reasoning in Volkart that the shorts had an
obligation to secure supplies of uncertificated cotton to
reduce congestion in the delivery of certificated cotton.
Cargill was charged with manipulating the futures market for
soft red winter wheat after accumulating 62 percent of the open
long interest in soft red winter wheat futures--nearly 2
million bushels--just prior to the close of trading on the
contract, as well as holding most of the cash market supply of
soft red winter wheat in Chicago warehouses. In determining
that Cargill had sufficient market power to find manipulation,
the court of appeals found that due to differences in use,
price, and quality, the supplies of hard wheat in the Chicago
area were not ``reasonably interchangeable'' with the
deliverable supplies of soft wheat. The court concluded,
``Since there was no soft red winter wheat available in
significant quantities from sources other than Cargill, the
conclusion is inescapable that the shorts could not fulfill
their contracts, at least to the extent of 2,000,000 bushels,
without coming to Cargill.'' \25\
---------------------------------------------------------------------------
\24\ Cargill v. Hardin, supra.
\25\ Id. at 1167.
---------------------------------------------------------------------------
With respect to Volkart, the Eighth Circuit stated:
If in a squeeze situation, the shorts must be forced
either to pay manipulated prices to offset their
contracts or in the alternative to bring in higher
priced outside supplies which are neither wanted nor
needed in the local market, then both the cash and the
futures market will be dislocated. . . . [W]e have been
shown no good reason why the futures price should
reflect the cost of bringing in a higher price and
grade of wheat for which there is no demand in the
local area. . . .\26\
---------------------------------------------------------------------------
\26\ Id. at 1173.
Despite the more recent ruling in Cargill, the CFTC has
followed the Volkart reasoning on several occasions. In In re
Indiana Farm Bureau, for example, the CFTC majority found that
it was ``irresponsible market behavior for shorts to enter the
delivery month, especially where low cash supplies are evident,
without making adequate delivery preparations.'' \27\ The CFTC
seemingly sanctioned squeezes that were not ``intentionally
created'' when it stated, ``[w]here a long has not
intentionally created or exploited a congested situation, the
long has a contractual right to stand for delivery or exact
whatever price for its long position which a short is willing
to pay in order to avoid having to make delivery.'' \28\
---------------------------------------------------------------------------
\27\ In re Indiana Farm Bureau (1982), supra at 31.
\28\ Id.
---------------------------------------------------------------------------
In Indiana Farm Bureau, CFTC Chairman Johnson concurred
with the result, but dissented from this reasoning. ``I cannot
join in the majority's view,'' the Chairman wrote, ``that it is
the `contractual right' of longs to demand as high an offset
price as possible from the shorts during periods of natural
market congestion.'' \29\ Commissioner Stone also dissented
from the majority's holding regarding the ability of the longs
to extract as high a price as possible, writing that this
approach ``runs contrary to many years of marketplace and
regulatory tradition. . . . The surveillance budgets of
regulators and self-regulators alike are largely devoted to
avoiding the extraction of premiums over cash prices in
congested markets. It is a dramatic break from the past if the
Commission majority now thinks it legal to extract a
substantial premium so long as as this was not the original
purpose of the dominant player at the time the congestion was
initiated.'' \30\
---------------------------------------------------------------------------
\29\ Id., at 59.
\30\ Id., at 107-9.
---------------------------------------------------------------------------
In 1987, in In re Cox and Frey, a majority of the CFTC
commissioners again reasoned it was primarily the obligation of
the shorts to avoid congestion by securing adequate supplies of
a deliverable commodity prior to contract expiry, rather than
the obligation of the longs to refrain from exploiting such
congestion.\31\ In Cox, the CFTC stated ``[t]he fact that the
local supply of a commodity is scarce does not release the
shorts from their obligation to honor their contractual
commitments to deliver. We do not believe that a valid analysis
of deliverable supply can be made in the context of the last
trading day.'' The CFTC rejected the position that ``premium
grades of a commodity at out-of-town locations must routinely
be excluded from deliverable supply calculations.'' \32\
---------------------------------------------------------------------------
\31\ In re Cox and Frey, CFTC Docket No. 75-16, 1987 WL 106879
(C.F.T.C), July 15, 1987.
\32\ Id., at 5.
---------------------------------------------------------------------------
Commissioner West dissented, stating, ``to simply define
the market congestion out of existence because the Commission
felt the shorts were negligent amounts to establishing a
``contributory negligence'' standard which creates an absolute
shield for the longs no matter how egregious their aberrant
behavior.'' \33\ Commissioner West added, ``If a bank leaves
its vault open overnight and a burglar takes the money, the
burglar cannot escape guilt based on the bank's negligence. . .
. Two wrongs do not make a right.'' \34\
---------------------------------------------------------------------------
\33\ Id., at 16.
\34\ Id., at 20.
---------------------------------------------------------------------------
Commissioner West agreed with the CFTC staff's argument
that under the Volkart standard, ``the more successful the
upward price manipulation, the larger the deliverable supply
will be, since at artificially high prices parties can profit
by disrupting the normal flow of the cash commodity and making
delivery to the manipulator on the futures market. At some
point, the manipulated futures price will be high enough to
warrant shipments of wheat into Chicago from around the
country, or even around the world.'' \35\
---------------------------------------------------------------------------
\35\ Id., at 17.
---------------------------------------------------------------------------
The conflict over the appropriate scope of the relevant
market is a key contributor to the confusion in the law of
manipulation. One noted analyst summed up the problem:
[T]he analysis of deliverable supplies resembles the
vacuous debates over market definition that occur in
antitrust cases. . . . [A]ccused manipulators attempt
to define the market as broadly as possible, and the
accusers attempt to define it as narrowly as possible.
. . . If manipulation cases turn on definitions of
deliverable supplies, they may simply decay into
struggles to draw firm boundaries where none naturally
exist. Establishing the quantity of a commodity
available at the competitive price requires information
on the value of alternative uses of the various stocks.
. . . [D]eliverable supply estimates provide little
information not already contained in prices, and making
a manipulation conviction turn on inevitably artificial
estimates of supplies invites confusion and
contradiction.\36\
---------------------------------------------------------------------------
\36\ Pirrong, supra at 974. This article approved of the holdings
in Cargill and Great Western, ``which imply that shorts are not
obligated to purchase fancy grades, or to go outside the delivery
market, in order to acquire deliverable supplies.'' Id. at 975. It was
extremely critical of the CFTC's reasoning in Cox (``defies logic'')
and similar arguments in Indiana Farm Bureau (``egregious errors'').
The author contended that under these two decisions and Volkart, ``it
is nearly impossible to find a long guilty of market power
manipulation.'' Id. at 976. See also Markham, supra at 355 (``Following
the decision in Cox, the CFTC's Division of Enforcement was left with
an almost impossible burden of proof in proving manipulation.'');
Perdue, supra at 377 n.192 (``But few courts agree on how broadly to
construe this concept: should it include, for example, only those goods
that were in fact deliverable at the expiration of the contract, or
should it include goods that could have been made deliverable if the
necessary steps had been taken? . . . The courts seem to lack any
coherent theory in analyzing these questions, and the approaches vary
considerably.'').
---------------------------------------------------------------------------
2. Specific Intent to Create an Artificial Price
In the recent Sumitomo case involving manipulation of the
copper markets, the CFTC stated ``the intent to create an
artificial or distorted price is the sine qua non of
manipulation.'' \37\
---------------------------------------------------------------------------
\37\ In re Sumitomo Corporation, 1998 CFTC LEXIS 96; Comm. Fut. L.
Rep. (CCH) para. 27,327, at 16.
---------------------------------------------------------------------------
Quoting Volkart, the CFTC said ``there must be a purpose to
create prices not responsive to the forces of supply and
demand; the conduct must be calculated to produce a price
distortion.''\38\ ``At bottom,'' according to the CFTC and the
courts, manipulation is ``the creation of an artificial price
by planned action, whether by one man or a group of men.'' \39\
---------------------------------------------------------------------------
\38\ Id., quoting Volkart Brothers, Inc. v. Freeman, 311 F.2d 52,
58 (5th Cir. 1962).
\39\ Id., quoting General Foods Corp. v. Brannan, 170 F.2d 220, 231
(7th Cir. 1948).
---------------------------------------------------------------------------
In several recent administrative cases the CFTC has
emphasized that the degree of intent required to establish that
a manipulation has occurred is not simply a general intent to
undertake the conduct in question, but rather it is conduct
undertaken with a manipulative intent akin to the mens rea
requirement in the criminal law. In other words, the accused
must actually have intended that an artificial price result
from his or her conduct.
Similar to proving intent to fix prices or restrain trade
in violation of the antitrust laws, proving specific intent in
commodity price manipulation cases necessarily relies on
circumstantial evidence. The CFTC has explained, ``Since it is
impossible to discover an attempted manipulator's state of
mind, intent must of necessity be inferred from the objective
facts and may, of course, be inferred by a person's actions and
the totality of circumstances.'' \40\
---------------------------------------------------------------------------
\40\ In re Indiana Farm Bureau Cooperative Ass'n, Inc., 1982 CFTC
LEXIS 25, Comm. Fut. L. Rep. (CCH) para. 21,796 ['82-'84 Transfer
Binder] (CFTC Dec. 17, 1982). See also In the Matter of Graystone Nash,
Inc., et al., 1996 SEC LEXIS 3545 (SEC June 27, 1996) (proof of
manipulation under the Securities Exchange Act ``almost always depends
on inferences drawn from a mass of factual data. Findings must be
gleaned from patterns of behavior, from apparent irregularities, and
from trading data. When all of these are considered together, they can
emerge as ingredients in a manipulative scheme designed to tamper with
free market forces.''); citing Herman & MacLean v. Huddleston, 459 U.S.
375, 390-91 n.30 (1983); Santa Fe Industries v. Green, 430 U.S. 462,
475 (1977); Pagel Inc. v. SEC, 803 F.2d 942, 946 (8th Cir. 1986); Mawod
& Co., 591 F.2d 588, 596 (10th Cir. 1979).
---------------------------------------------------------------------------
The CFTC has found several fact patterns to be indications
of manipulative intent. The purposeful reduction of supplies in
a tight market is one such indication. In a case involving an
alleged squeeze of the frozen concentrated orange juice market,
the CFTC stated that ``manipulative intent may be inferred when
the holder of a long position increases his position despite
knowledge of a congested situation in the underlying
contract.'' \41\ Put another way, ``a congested market is not
an appropriate venue for unrestrained self-interest.'' \42\
---------------------------------------------------------------------------
\41\ In re Louis Abrams and Theodore Butler, 1993 CFTC LEXIS 136,
at *14 (CFTC, May 4, 1993).
\42\ In re Louis Abrams, 1995 CFTC LEXIS 196, at *10, Comm. Fut. L.
Rep. (CCH) para. 26,479 (CFTC, July 31, 1995).
---------------------------------------------------------------------------
On the other hand, the CFTC will not find manipulation when
a trader merely holds out for the best price in a congested
market, for example where the futures contract is near
expiration and the physical supply of the commodity is
insufficient to cover the outstanding future contracts
requiring delivery. ``Seeking the optimum price from the
futures market (risking, of course, the possibility of
delivery) is not unlawful. Manipulative intent may be inferred,
however, where, once the congested situation becomes known to
him, the long exacerbates the situation by, for example,
intentionally decreasing the cash supply or increasing his long
position in the futures market.'' \43\
---------------------------------------------------------------------------
\43\ In re Indiana Farm Bureau Cooperative Ass'n, Inc., 1982 CFTC
LEXIS 25, Comm. Fut. L. Rep. (CCH) para. 21,796 ['82-'84 Transfer
Binder] (CFTC Dec. 17, 1982).
---------------------------------------------------------------------------
The distinction between taking advantage of a ``natural''
squeeze or congestion by holding out for a higher price, versus
intentionally creating or exacerbating such conditions by
purposely reducing or withholding the supply of the deliverable
commodity, has caused controversy and confusion. As one
commentator put it:
The doctrine of a ``natural'' squeeze provides a
large trader with a manipulation option; if the trader
creates a large long position for a legitimate hedging
or speculative purpose, the trader can exercise his
option to squeeze the market if conditions subsequently
change to make manipulation profitable. One can imagine
the havoc that would result if judges were to find only
those who meticulously planned a murder guilty of the
crime and to free those who merely killed impulsively
when the opportunity presented itself. The precedents
in manipulation law create the conditions for such
chaos in futures markets.\44\
---------------------------------------------------------------------------
\44\ Pirrong, supra at 987.
Another commenter has noted that persons seeking to
manipulate the price of a commodity are not likely to be
thinking about whether the affected price levels are
``artificial'' or do not reflect the forces of supply and
demand; the traders only intend ``to make as much money as
possible.'' ``To frame an intent element in terms of something
that most manipulators have either never thought of, or if they
have thought of it, are totally indifferent to, simply invites
unnecessary complication. . . . [C]ourts either must rely on
convoluted notions of intent or attribute to people intentions
and expectations bearing little relation to what they actually
think about or even reasonably can be expected to think
about.'' \45\
---------------------------------------------------------------------------
\45\ Perdue, supra at 375-6.
---------------------------------------------------------------------------
The Law of Manipulation Under British Commodity Law
Like U.S. law, U.K. commodities law distinguishes
between a legal squeeze, which results from legitimate
commercial transactions, and an ``abusive'' squeeze,
which results from trading activity undertaken
partially for the purpose of ``positioning the price at
a distorted level.'' The U.K. Financial Services
Authority (FSA) Handbook, which incorporates the Code
of Market Conduct, the law governing the operation of
financial and commodity markets in the U.K., explains,
``Squeezes occur relatively frequently when the proper
interaction of supply and demand leads to market
tightness, but this is not of itself abusive.'' \46\
---------------------------------------------------------------------------
\46\ FSA Handbook, Release 002, at Sec. 1.6.15 (December 2001).
British law does not prohibit conduct that results in
a squeeze if the trading activity is undertaken for a
legitimate commercial justification other than to
squeeze the market. According to the FSA Handbook, the
U.K. Code of Market Conduct ``does not restrict market
users trading significant volumes where there is a
legitimate purpose for the transaction . . . and where
the transaction is executed in a proper way, that is, a
way which takes into account the need for the market as
a whole to operate fairly and efficiently.'' \47\
---------------------------------------------------------------------------
\47\ Id., Sec. 1.6.10.
Under U.K. law, an abusive squeeze of a commodity
occurs when a person with (1) ``a significant influence
over the supply of, or demand for, or delivery
mechanisms for a . . . relevant product; and (2) a
position . . . in an investment under which quantities
of the . . . relevant product in question are
deliverable; engages in behaviour with the purpose of
positioning at a distorted level the price at which
others have to deliver, take delivery, or defer
delivery to satisfy their obligations.'' \48\ The Code
notes that price distortion ``need not be the sole
purpose of entering into the transaction or
transactions, but must be an actuating purpose.''
---------------------------------------------------------------------------
\48\ Id., at Sec. 1.6.13E.
---------------------------------------------------------------------------
3. Artificial Price
As one CFTC Commissioner wrote, although ``[p]rice
artificiality is an essential ingredient of a completed
manipulation,'' establishing artificiality is not sufficient to
establish that manipulation has occurred in violation of the
Act. ``It is like a new cadaver at the morgue, a trigger for
further inquiry but not in itself the proof of an offense.''
\49\
---------------------------------------------------------------------------
\49\ Indiana Farm Bureau, supra at 75-6 (Stone, dissenting).
---------------------------------------------------------------------------
Although the concept of an artificial price appears to be
straightforward and intuitive, the means for determining
whether the price of a commodity is ``artificial'' has proved
to be remarkably difficult. ``Defining manipulation as the
creation of an artificial price simply substitutes one
unhelpful term for another.'' \50\ Part of the difficulty stems
from the fact that the futures market itself is an
``artificial'' creation and there is no fixed baseline against
which to measure the performance of the market. Moreover, to
the extent that buyers and sellers seek to bid the price of the
commodity up or down in any given transaction, any resulting
price from such transactions could be termed ``artificial.''
\51\
---------------------------------------------------------------------------
\50\ Id. at 348. In Indiana Farm Bureau, supra at 9, the CFTC
stated, ``When the aggregate forces of supply and demand bearing on a
particular market are all legitimate, it follows that the price will
not be artificial. On the other hand, when a price is effected [sic] by
a factor which is not legitimate, the resulting price is necessarily
artificial. Thus, the focus should not be as much on the ultimate
price, as on the nature of the factors causing it.''
Commissioner Stone took issue with the majority's statement. ``To
make the identification of illegitimate market forces a prerequisite
for a finding of artificial price is an insufficient improvement.
Legitimacy with respect to supply and demand is undefined in law and
economics.'' Id. at 80 (Stone, dissenting).
\51\ ``[T]he determination of the `true' economic price will turn
on an after-the-fact economic analysis of the price a willing buyer and
a willing seller would have paid in the absence of the manipulation.
But this economic analysis is so complicated and affected by so many
factors that it is often impossible to determine what the `true' price
was.'' Markham, supra at 284. See also Fischel and Ross, supra at 546
(``None of these tests distinguishes artificial prices from non-
artificial prices because, whenever unusual conditions of supply and
demand occur, such comparisons will demonstrate that prices are
`unusual.' '').
---------------------------------------------------------------------------
In examining an allegation of manipulation of the price of
a commodity, both the courts and the CFTC have examined the
``web of prices'' in the various cash and futures markets for
that and related commodities. These inquiries have analyzed the
relationship between the price of the affected commodity in the
affected market with the contemporaneous spot and futures
prices of the commodity in other markets; the price of related
commodities; the relationship between the near-term and the
long-term price for the commodity on the futures markets, and
historical price data.\52\ This effort may entail a very
complex factual and economic analysis. Indeed, the complexity
of the analysis required to thoroughly analyze the requisite
amount of market data ``may strain the competence of the
regulatory agency and the budget of the respondent to the point
that it is unlikely to be undertaken in particular cases.''
\53\
---------------------------------------------------------------------------
\52\ See, e.g., Cargill v. Hardin, supra. An exposition of the
obstacles one faces in proving that a prevailing price was
``artificial'' is found in Stanford University Professor Jeffrey
Williams's Manipulation on Trial, an account of one of the civil
lawsuits resulting from the Hunt brothers' near-cornering of the silver
market.
\53\ Gray, Economic Evidence in Manipulation Cases, CBOT Seminar
Report on Research on Speculation 108, 110 (Nov. 1980); quoted in
Perdue, supra at 368 n.136.
---------------------------------------------------------------------------
4. Causation
The problems with proving that a trader ``caused'' an
artificial price are closely related to the problems in
defining the relevant market and in determining the alleged
manipulator's intent. Since there are always two parties to any
transaction in the futures market, it may be impossible to
determine which party ``caused'' an increase in price. ``Asking
whether the buyer or the seller `caused' the price, thus is
useless--like trying to cut with only one blade of a scissor. .
. . There simply exists no meaningful way to determine who, in
the two-sided bargaining process, `caused' the price.'' \54\
---------------------------------------------------------------------------
\54\ Perdue, supra at 376.
---------------------------------------------------------------------------
In most instances the spot and futures prices of a
commodity at any time are determined by a multitude of
factors--aggregate supply and demand, political events,
logistical disturbances, to name a few. Indeed, what makes a
market a market is that the various participants have differing
views as to the influence of each of those factors on prices.
If there were no uncertainty or difference of opinion regarding
how each of those factors affected the future price of a
commodity, there would not be much of a futures market.
Isolating and quantifying, in retrospect, the price impact of
any single one of the many factors and how the various market
participants reacted to that factor, would be an impossible
task in many situations.\55\
---------------------------------------------------------------------------
\55\ One of the expert witnesses in the litigation that followed
the Hunt manipulation of the silver market concluded: ``Most
frustrating to those concerned with commodity markets, the Hunt trial
did not resolve the extent to which the Hunts caused the price spike.
The trial itself was filled with the ambiguity, contradictions, and
inconclusiveness found in the turmoil in the silver market during 1979
and 1980.'' Williams, supra at 4.
---------------------------------------------------------------------------
In Volkart, Indiana Farm Bureau, and Cox, responsibility
for a price increase was placed upon the shorts, who were found
culpable for failing to arrange for delivery of a substitute
commodity. In situations like these, the longs will not be
found to have caused the increase in price.
The conflicts in existing case law has led one observer to
conclude, ``major precedents concerning the evidence necessary
to determine causation in a manipulation case may provide
substantial legal shelter to a cornerer. Most importantly, the
potential for the accused to refute causation by convincing a
court or commissioners that the deliverable supply is large may
allow him to escape unscathed.'' \56\
---------------------------------------------------------------------------
\56\ Pirrong, supra at 984.
---------------------------------------------------------------------------
5. Summary
The CEA does not define the offense of ``manipulation'' and
the case law is confusing and contradictory. Despite the
extensive analysis and criticism of the current law of
manipulation, no one has yet formulated an alternative standard
that would satisfy all of the problems that have been
identified with the current law or the proposed alternatives.
And there is not much reason for optimism that additional
analysis ever will find one. In the final analysis, the concept
of manipulation may necessarily remain ambiguous. After
struggling with the definition of manipulation during the Hunt
brothers' trial for manipulating the silver market, one of the
lawyers for the plaintiffs commented, ``[T]he flexible, open-
ended concept of manipulation should continue to prevail over
any fixed formula rigidly defining manipulation. Otherwise, the
creation of the next new form of manipulation will be
encouraged rather than deterred.'' \57\
---------------------------------------------------------------------------
\57\ Williams, supra at xviii (Foreword of Thomas O. Gorman).
---------------------------------------------------------------------------
One Federal appellate court has likened the difficulty in
defining manipulation to Supreme Court Justice Potter Stewart's
legendary observation about the difficulty in defining
obscenity: ``Sophisticated economic justification for the
distinctions made in this area of law may at times seem
questionable. Sometimes the `know it when you see it' test may
appear most useful.'' \58\
---------------------------------------------------------------------------
\58\ Frey v. CFTC, 931 F.2d 1171, 1175 (7th Cir. 1991). See also,
Lower, Disruptions of the Futures Market: A Comment on Dealing with
Market Manipulation, 8 Yale J. on Reg. 391 (1991).
---------------------------------------------------------------------------
The difficulties in defining the offense of manipulation
and in proving, after-the-fact, manipulation has occurred means
that it is extraordinarily difficult to prosecute claims of
manipulation. One former Chief Counsel of the CFTC Division of
Enforcement has written, ``[U]nder present law the crime of
manipulation is virtually unprosecutable, and remedies for
those injured by price manipulation are difficult to obtain.
Moreover, even where a prosecution is successful, the
investigation and effort necessary to bring a case will involve
years of work, enormous expenditures, as well as an extended
trial.'' \59\ Other former senior CFTC officials interviewed by
the Subcommittee staff agreed that retrospective manipulation
cases were exceedingly difficult to prosecute. Current CFTC
staff interviewed by the Subcommittee staff indicated that as a
general matter manipulation cases entailed extensive market
analysis, required heavy use of staff resources, were generally
vigorously contested by the parties, and took years to
prosecute.
---------------------------------------------------------------------------
\59\ Markham, supra at 282.
---------------------------------------------------------------------------
In light of the current state of the law, the following
observation sensibly warns against heavily relying on after-
the-fact prosecutions to deter manipulation:
[T]he current precedents make it extremely difficult
to find a trader guilty of manipulation even in cases
in which the economic analysis suggests that the trader
has indeed manipulated. Given this state of affairs, ex
post deterrence is currently a weak bulwark against
future manipulations.\60\
---------------------------------------------------------------------------
\60\ Pirrong, supra at 959.
---------------------------------------------------------------------------
B. Market Oversight to Detect and Prevent Manipulation
1. CFTC Market Oversight
The goals of the CFTC's market oversight and surveillance
program are to preserve the ``economic functions of the futures
and option markets under its jurisdiction by monitoring trading
activity to detect and prevent manipulation or abusive
practices, to keep the Commission informed of significant
market developments, to enforce Commission and exchange
speculative position limits, and to ensure compliance with
Commission reporting requirements.'' \61\ The CFTC's market
surveillance program seeks to ``identify situations that could
pose a threat of manipulation and to initiate appropriate
preventive actions. Each day, for all active futures and option
contract markets, the Commission's market surveillance staff
monitors the daily activities of large traders, key price
relationships, and relevant supply and demand factors in a
continuous review for potential market problems.'' \62\
---------------------------------------------------------------------------
\61\ CFTC, The CFTC Market Surveillance Program, at CFTC website:
http://www.cftc.gov/opa/backgrounder/opasurveill.htm.
\62\ Id.
---------------------------------------------------------------------------
In physical commodity markets, the CFTC will most closely
examine those situations in which the market is most
susceptible to manipulation--when the deliverable supply of the
commodity is small in relation to the outstanding positions
held by traders. In these circumstances, the CFTC will examine
the positions held by the largest long traders, the deliverable
supplies not already owned by those traders, whether the long
traders are likely to demand delivery, whether the short
traders are capable of making delivery, and the price of the
commodity on the futures market near contract expiration as
compared to the price of the commodity on the cash market.
The CFTC explains how it analyzes market information:
Surveillance economists prepare weekly summary
reports for futures and options contracts that are
approaching their critical expiration periods. Regional
surveillance supervisors immediately review these
reports. Surveillance staff advise the Commission and
senior staff of potential problems and significant
market developments at weekly surveillance meetings so
that they will be prepared to take prompt action when
necessary.\63\
---------------------------------------------------------------------------
\63\ Id.
A more colorful description of the weekly surveillance
meetings is found in Stephen Fay's Beyond Greed, a tale of the
---------------------------------------------------------------------------
Hunt brothers' attempt to corner the silver market:
The significant business of the CFTC takes place on
Friday mornings, behind closed doors, in a gloomy, top-
floor back room. The room is dominated by a large,
round, laminated table, cluttered with pencils, pads,
and microphones--which are there not to make the
conversation but to tape it for the record. The
commissioners listen to the weekly surveillance
briefings, in which the staff discuss price
fluctuations and reveal any substantial changes in the
positions of market traders and big speculators, which
must be reported confidentially to the CFTC each
day.\64\
---------------------------------------------------------------------------
\64\ Beyond Greed, supra at 109-110.
According to CFTC staff, no written record is kept of these
meetings and ``what happens in the room stays in the room.''
\65\
---------------------------------------------------------------------------
\65\ Interview with Subcommittee staff.
---------------------------------------------------------------------------
If the CFTC believes that a market is unduly congested or
there is a threat of manipulation, it may take any one or more
of a variety of actions, either formal or informal, to ensure
that trading remains orderly. Generally, the CFTC's oversight
program obtains information from and shares information with
the affected futures exchanges, and corrective actions are
coordinated.
The CFTC explains the types of informal action it may take
with an exchange to maintain orderly trading:
Potential problem situations are jointly monitored
and, if necessary, verbal contacts are made with the
brokers or traders who are significant participants in
the market in question. These contacts may be for the
purpose of asking questions, confirming reported
positions, alerting the brokers or traders as to the
regulatory concern for the situation, or warning them
to conduct their trading responsibly. This
``jawboning'' activity by the Commission and the
exchanges has been quite effective in resolving most
potential problems at an early stage.\66\
---------------------------------------------------------------------------
\66\ The CFTC Market Surveillance Program.
Current and former CFTC officials interviewed by the
Subcommittee staff believe that ``jawboning'' is an effective
tool to prevent manipulations in commodity markets. One former
CFTC official stated that the Chairman of the Commission would
make perhaps five or six telephone calls per year to
``jawbone'' with exchange officials, top company officers, and
large traders. These officials believe that the CFTC's anti-
manipulation program is far more successful as a result of this
behind-the-scenes action than indicated by information on the
public record, including administrative and judicial decisions
in after-the-fact CFTC prosecutions.
If neither the exchanges nor jawboning by the CFTC
alleviates the agency's concerns regarding the potential for
manipulation, the CFTC has a wide range of ``emergency powers''
that it can exercise to maintain order in the markets. In an
emergency the CFTC can require the liquidation of positions,
establish limits on positions in the market, extend the period
for delivery under futures contracts, or, in the extreme, close
the market.\67\ The CFTC has used these emergency powers
sparingly. ``The fact that the CFTC has had to take emergency
actions only four times in its history demonstrates its
commitment to not intervene in markets unless all other efforts
have been unsuccessful.'' \68\
---------------------------------------------------------------------------
\67\ In Beyond Greed, Fay notes ``there is virtually nothing the
CFTC cannot do'' in the face of ``threatened . . . or actual
manipulations'' to ensure the orderly operation of the market. But,
writes Fay, ``There is just one drawback to this panoply of regulatory
power: the act omits any definition of `manipulation' or `squeeze' or
`corner.' Moreover, the CFTC is committed to show intent to
manipulate--a difficult thing to do even in so apparently
straightforward a case as Bunker and Herbert's excursion into soybeans
in 1977. This is the Catch-22 of commodities regulation: the law gives
the CFTC immense power, and makes it almost impossible to deploy it.''
Id. at 112.
\68\ The CFTC Market Surveillance Program.
---------------------------------------------------------------------------
The CFTC obtains the information it uses to analyze the
futures markets from publicly available sources, daily reports
provided by the exchanges, and from its large-trader reporting
system. Publicly available data includes information on supply
and demand conditions, price information, trading volumes and
open interest data on the number of outstanding long and short
contracts. The exchanges report daily to the CFTC on the daily
positions and trades of the members of their clearing houses.
This information identifies the firms that hold the largest
positions in the market, or that clear the largest trades, but
it does not identify the firms or persons that actually hold
the underlying positions. To determine this latter information,
the CFTC relies upon the large-trader reporting system.\69\
---------------------------------------------------------------------------
\69\ See, CFTC, The CFTC's Large-Trader Reporting System; available
at CFTC website, at http://www.cftc.gov/opa/backgrounder/opa-ltrs.htm.
---------------------------------------------------------------------------
The CFTC recently testified before the Congress on the
importance of the large-trader reporting system:
The heart of the Commission's direct market
surveillance is a large-trader reporting system, under
which clearing members of exchanges, commodity brokers
(called futures commission merchants, or FCMs), and
foreign brokers electronically file daily reports with
the Commission. These reports contain the futures and
option positions of traders that hold positions above
specific reporting levels set by CFTC regulations.
Because a trader may carry futures positions through
more than one FCM and because a customer may control
more than one account, the Commission routinely
collects information that enables its surveillance
staff to aggregate information across FCMs and for
related accounts.\70\
---------------------------------------------------------------------------
\70\ Statement of James E. Newsome, Chairman, CFTC, Hearing before
the Senate Committee on Energy and Natural Resources, Enron
Corporation's Collapse, 107th Cong., 2nd Sess., January 29, 2002, at
27.
The CFTC devotes a significant portion of its annual budget
and its personnel to market oversight. For Fiscal Year 2003,
the CFTC requested a budget of $10.6 million--about 13 percent
of the agency's total budget--for its Market Surveillance,
Analysis, and Research program within the Division of Economic
Analysis. According to the CFTC's Budget Request for FY 2003,
``The primary responsibility of the Market Surveillance,
Analysis, and Research program is to foster markets that
accurately reflect the forces of supply and demand for the
underlying commodity and are free of disruptive activity. By
detecting and protecting against price manipulation, this
program assists the markets in performing the vital economic
functions of price discovery and risk transfer (hedging).''
Under the request, ``57 FTE's will be employed to detect and
prevent threats of price manipulation or other major market
disruptions caused by abusive trading practices.'' \71\
---------------------------------------------------------------------------
\71\ For FY 2003, the CFTC requested $22.9 million for the Division
of Enforcement. Only a fraction of the enforcement budget is devoted to
manipulation cases. In FY 2001, for example, the CFTC filed 3
administrative complaints in manipulation cases. During the same year,
the CFTC filed 7 cases involving the sale of illegal foreign currency
futures or options, 25 cases involving fraud, 4 cases involving
management of customer funds, and various other administrative actions.
The enforcement division also works with other law enforcement agencies
on a variety of financial fraud, conspiracy, and money laundering
actions. CFTC, FY 2001 Annual Report. A comparison of the CFTC's Budget
Request with its Annual Report indicates that in the normal course of
business the CFTC devotes far more resources to the before-the-fact
prevention of manipulation than to the after-the-fact prosecution of
manipulation.
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2. Market Oversight by Approved Futures Exchanges
In order for a commodity exchange to obtain CFTC approval
to trade in futures contracts, the exchange must have its own
market oversight and enforcement program to detect and prevent
excessive speculation and market manipulation. Each of the
``designated contract markets'' authorized by the CFTC has
established such a program, and works closely with the CFTC to
prevent manipulation and other trading abuses.\72\ The CFTC
periodically reviews each of the approved exchanges' market
surveillance and enforcement programs to ensure they remain in
compliance with the standards established by the CFTC.
---------------------------------------------------------------------------
\72\ See Table A.2-1 for a list of the designated contract markets
currently in operation.
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The NYMEX, the largest exchange for energy contracts,
describes its self-regulatory program as follows:
The New York Mercantile Exchange enforces a rigorous
self-regulatory program closely monitoring and
regulating floor trading activity to prevent market
manipulation and other anti-competitive activity. The
Exchange has taken the lead in developing and
maintaining new trade surveillance enhancements
including the addition of public representatives to a
revamped disciplinary panel, increased penalties, and
tightened recording procedures. During numerous
hearings on the reauthorization of the CFTC, Exchange
officials stressed the Exchange's intolerance of
wrongdoing, and encouraged legislation aimed at further
preserving public confidence in the markets. The
Exchange's rules and procedures have been carefully
honed as a result of nearly 125 years of experience in
building one of the world's safest and most liquid
futures and options markets. The Exchange board of
directors and staff remain committed to providing the
vigilance and financial support necessary to preserve
the highest levels of customer confidence in the
integrity of our market.\73\
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\73\ NYMEX, Safeguards and Standards.
In 1998, the NYMEX Trade Practice Surveillance section,
which investigates and prosecutes NYMEX rule violations, had a
staff of 21 persons,\74\ and the Market Surveillance section
had a staff of 15.\75\ The Chicago Mercantile Exchange (CME)
had 10 full-time employees in its market surveillance division,
which is responsible for monitoring and reviewing daily price
movements, volumes and open interest in CME contracts, and
other futures market activity.\76\ It appears that the approved
exchanges, in aggregate, devote a level of resources to
surveillance and enforcement that is comparable to the level of
resources that the CFTC devotes to these activities.\77\
Altogether, then, on the order of a hundred individuals in the
government and on the designated exchanges monitor billions of
dollars in commodity transactions each day.
---------------------------------------------------------------------------
\74\ CFTC, Rule Enforcement Review of the Commodity Exchange, Inc.
Division of the New York Mercantile Exchange (1999).
\75\ CFTC, Rule Enforcement Review of the Market Surveillance
Program at the COMEX Division of the New York Mercantile Exchange
(1998).
\76\ CFTC, Rule Enforcement Review of the Chicago Mercantile
Exchange (1999).
\77\ The New York Board of Trade has a 21-person compliance
division. CFTC, Rule Enforcement Review of the New York Cotton Exchange
(2001).
---------------------------------------------------------------------------
The designated exchanges have several types of regulations
and programs to ensure orderly trading and prevent
manipulation. First, the exchanges impose a variety of
financial requirements on firms that are members of the
exchange to ensure the creditworthiness of the parties trading
on the exchange. One of the major advantages of purchasing
exchange-traded futures contracts rather than OTC derivatives
or swaps for hedging or speculation is the much greater
assurance of creditworthiness that the exchange-traded
instruments provide. In an OTC transaction, each party assumes
the credit risk of the other party. In a transaction conducted
on an approved exchange, with a clearinghouse that is
capitalized by its members, the clearinghouse effectively acts
as the counterparty to all transactions and so eliminates
counterparty credit risk. To ensure the financial integrity of
the market, the exchanges require the maintenance of sufficient
margins to cover market fluctuations, and require clearing
member firms to maintain sufficient capitalization to cover
their operations, including the trades made on behalf of their
customers.
To ensure orderly trading, the exchanges have established
daily price limits for most commodity futures contracts, which
limit the amount the price of the contract can increase or
decrease in 1 day; position limits for clearing members of the
exchange to ensure each clearing member has sufficient capital
to cover its commitments; position limits for customers on
contracts for the current delivery month to prevent commodity
squeezes in the final month of the contract; and reporting
requirements for customers who acquire large positions in the
futures or options markets.
Like the CFTC, the exchanges have market oversight programs
to ensure that trading is orderly and in compliance with
financial and trading regulations. As the NYMEX explains,
``daily surveillance is performed to ensure that Exchange
prices reflect cash market price movements, that the futures
market converges with the cash market at contract expiration,
and that there are no price distortions and no market
manipulations.'' \78\ Generally, the exchanges hold weekly
meetings to review market conditions. Market oversight meetings
may be held more frequently if unusual market conditions
warrant.
---------------------------------------------------------------------------
\78\ Safeguards and Standards.
---------------------------------------------------------------------------
In sum, the day-to-day market oversight by the approved
exchanges is one of the key elements in preventing manipulation
in the commodity futures markets. The exchanges devote a level
of resources to market oversight and enforcement that is
comparable to the level of resources the CFTC devotes to these
activities, and the exchanges work closely with the CFTC to
monitor the markets and take action, when necessary, to ensure
that trading remains orderly and in compliance with
regulations. The CFTC and exchange anti-manipulation programs
work together to detect, deter, and punish market manipulation.
C. Lessons Learned from the Sumitomo Manipulation of the Copper
Markets
Summary: The Sumitomo manipulation of the global copper
market in the mid-1990's demonstrated the importance of
monitoring over-the-counter markets and of sharing of
information among regulators.
1. Sumitomo Manipulation of the Copper Markets \79\
---------------------------------------------------------------------------
\79\ The facts regarding Sumitomo's manipulation set forth herein
are taken from the Offer of Settlement agreed to by the CFTC and
Sumitomo Corporation in In re Sumitomo Corporation, 1998 CFTC LEXIS 96,
Comm. Fut. L. Rep. (CCH) para. 27,327 (CFTC, May 11, 1998). The facts
regarding the CFTC's response are taken from an article written by
Brooksley Born, CFTC Chair at the time. Born, International Regulatory
Responses to Derivatives Crises: The Role of the U.S. Commodity Futures
Trading Commision, 21 NW. J. Intl. L. & Bus. 607 (2001).
---------------------------------------------------------------------------
Sumitomo is a Japanese corporation that has marketed copper
metal for hundreds of years. During the time period relevant
here, Sumitomo's Copper Metals Section, also known as
Sumitomo's ``Copper Team,'' was a major supplier of copper
cathode to Asian manufacturers. Historically, Sumitomo
extensively used the futures market to hedge against the risks
presented by the volatility in copper prices.
Yasuo Hamanaka began trading in copper for Sumitomo in
1973, and was promoted to head the Copper Team in 1987. Just
prior to Hamanaka's promotion, the Copper Team had begun to
lose significant amounts of money from copper trades. These
losses were compounded by losses incurred as a result of
speculative trades made by Hamanaka and another trader in an
attempt to compensate for the losses in the physical market.
Hamanaka did not enter the losses from these trades on
Sumitomo's normal bookkeeping system; rather he recorded the
transactions in a personal notebook.
Shortly after he was promoted to head the Copper Team,
Hamanaka began plotting to manipulate the copper market to
recover some of Sumitomo's losses. Beginning in late 1993,
Hamanaka entered into a series of unusual copper purchasing
agreements with a newly-formed U.S. copper merchant firm,
whereby both Sumitomo and the U.S. firm had an incentive for
the transactions to be conducted at higher prices. According to
the CFTC, much of the copper purchased by Sumitomo under these
contracts was immediately resold to the U.S. firm's supplier
and was never actually delivered to Sumitomo.\80\
---------------------------------------------------------------------------
\80\ The Sumitomo settlement agreement did not name ``the U.S.
copper merchant'' with which Sumitomo traded.
---------------------------------------------------------------------------
As part of their scheme to manipulate the copper market,
Hamanaka and his co-conspirators attempted to acquire all of
the stocks of physical copper in the warehouses owned by the
London Metals Exchange (LME). By November 1995, Sumitomo owned
and controlled 100 percent of the copper inventory in LME
warehouses, including the inventory in the newly opened LME
warehouse in Long Beach, California. ``As Sumitomo's copper
trader knew, the concentration of ownership of all, or
essentially all, of the LME warehouse stocks in the hands of
cooperating market participants and the withholding of such
stocks from the market would have the effect of increasing the
price of copper and also creating a large backwardation. These
developments allowed Sumitomo's copper trader to liquidate,
lend or roll forward Sumitomo's large market holdings at the
higher price or price differential and thereby earn significant
profits for Sumitomo.'' \81\ At the same time, Sumitomo had
acquired and maintained large and controlling futures positions
on the LME, which ``bore little legitimate relationship to the
marketing of physical copper to Sumitomo's customers, but
rather were specifically designed to cause artificial prices
and price relationships.'' \82\
---------------------------------------------------------------------------
\81\ In re Sumitomo Corporation, supra, at *11-12. In the futures
markets for commodities that can be stored easily, such as copper, the
market is generally in contango rather than backwardation, as the
producers or sellers of the commodity for future delivery will obtain a
market premium to compensate them for the storage costs of the
commodity to be delivered in the future. The crude oil markets are an
exception to this general rule, as crude oil is more difficult to store
than a metal such as copper or silver, and refiners are willing to pay
a slight premium for the convenience of having an assured prompt supply
of crude oil to keep their refineries in continuous operation. A large
backwardation in the copper or silver market therefore indicates some
type of immediate supply disruption or shortage.
\82\ Id., at 12.
---------------------------------------------------------------------------
In early 1995, the NYMEX and the CFTC became concerned
about the price of copper on global markets, especially on the
NYMEX and LME. Working with the NYMEX surveillance program, the
CFTC surveillance staff recognized several unusual price
relationships in the copper markets, such as increased
volatility and the significant backwardation that had arisen
due to Sumitomo's extraordinarily large physical holdings. For
example, the cash price of copper on the LME had risen from
about $1,900 per metric ton in June 1994, to about $2,500 per
ton by the end of September 1994.
In addition, the CFTC and NYMEX market oversight staffs
``detected unusual activity in warehouse stocks.'' \83\
Although New York spot prices for copper were higher than the
spot prices for copper on the LME in the summer and fall of
1995, inventories of copper in the LME warehouses--including
the new LME warehouse in Long Beach--continued to increase. As
the NYMEX explains, ``Exchange officials and many members found
this curious since exchange warehouses are intended to be the
supplier or receiver of last resort. When demand for physical
product is high, material should not continue to accumulate in
an exchange warehouse; logically there should have been a
reduction in LME stocks. . . .'' \84\ In late 1995, the NYMEX
Vice-President called the LME warehouse inventories ``a sign of
sickness, not well-being,'' and inconsistent with rational
commercial activity.\85\
---------------------------------------------------------------------------
\83\ Born, supra at 622.
\84\ NYMEX, Collapse of Copper Prices Draws Attention to
Differences in Oversight on the Exchange and Foreign Markets (1996).
\85\ Id.
---------------------------------------------------------------------------
Although both the NYMEX and CFTC had spotted ``unusual
activity,'' they could not discover the cause of such activity,
and, as a result, were unable to take any preventive action to
stop the manipulation. The NYMEX and CFTC examined the
positions of traders on the NYMEX, but no unusual positions
were detected. No large-trader reports had been filed.
Hamanaka and his co-conspirators had taken certain basic
measures to evade NYMEX and CFTC oversight. They had acquired
their futures and options positions on the LME and in the OTC
markets rather than on the NYMEX in order to avoid the
transparency and large-trader reporting requirements of the
NYMEX and the CFTC. Indeed, Hamanaka ``shunned the Comex
[division of NYMEX], not only because it lacked the liquidity
for the volume of trading he was doing, but also, he said in
past interviews, because its regulations were too stringent.''
\86\
---------------------------------------------------------------------------
\86\ Stephanie Strom, A Market Ripe for Manipulation; Laxity in
London Opened Door for a Sumitomo Trader, New York Times, July 12,
1996.
---------------------------------------------------------------------------
The LME did not have comparable reporting requirements, and
trading was much less transparent than on the American
exchanges. On the LME, traders were ``allowed to meet daily
margin calls with credit, rather than cash, letting them amass
large positions without attracting the attention of their
corporate treasurers, who would otherwise have to cut them
checks. The Comex requires cash.'' \87\
---------------------------------------------------------------------------
\87\ Id.
---------------------------------------------------------------------------
After the Sumitomo manipulation was discovered, one NYMEX
official blamed the LME's lenient regulatory philosophy:
Unlike the strict reporting and disclosure
requirements of the Exchange's COMEX and NYMEX
Divisions that give those markets their transparency,
the corresponding rules on the LME are considerably
more lax where they exist at all. The result is an
opaque market where problems like Sumitomo's have
occurred with distressing regularity, including the tin
market default in 1985 and a $175 million loss suffered
by the Chilean copper producer Codelco in 1993 because
of alleged unauthorized trading.\88\
---------------------------------------------------------------------------
\88\ Id. In Chile, the losses at Codelco grew into a political
scandal dubbed ``Coppergate,'' and contributed to the fall of the
Chilean government. Garth Alexander and John Waples, Copper Meltdown,
Sunday Times, June 16, 1996.
The CFTC requested information from the U.K. Securities
Investment Board (SIB), but the SIB had neither the requested
information nor the inclination to co-operate with the CFTC.
Reflecting some of the attitudes in London, The Guardian
reported, ``The CFTC's direct approach to investigating
complaints lodged by its own members has been dubbed
``colonialism'' by some market participants in London.'' \89\
NYMEX appealed to the LME for information on the copper
markets, but it too was ``rebuffed.'' \90\ In response to the
complaints that the LME was too weak as a regulator, the chief
executive of the LME, David E. King, ``insisted that charges
that it lacks regulatory zeal are merely sour grapes from the
[New York Exchange], which has lost most of its market share in
copper to London in recent years.'' \91\
---------------------------------------------------------------------------
\89\ Paul Murphy, Complaints About American Regulators' London
Activity, The Guardian (London), January 30, 1996.
\90\ Strom, A Market Ripe for Manipulation; Laxity in London Opened
Door for a Sumitomo Trader, supra.
\91\ Id.
---------------------------------------------------------------------------
According to Brooksley Born, CFTC Chair during this period,
``the CFTC was frustrated in its ability to investigate the
causes of the price abnormalities during 1995 because it was
limited to information about the U.S. markets. At a time when
Sumitomo's manipulative scheme might have been stopped before
great harm was caused to copper market participants, the CFTC's
hands were tied by lack of information.'' \92\
---------------------------------------------------------------------------
\92\ Born, supra at 622.
---------------------------------------------------------------------------
In the absence of specific information about trading in the
copper markets, the CFTC was unable to detect or stop
Hamanaka's manipulation. In April 1996, following a series of
letters from the CFTC to the LME regarding the unusual activity
in the copper markets, Sumitomo began its own
investigation.\93\ When during this internal investigation a
Sumitomo clerk discovered a variety of unauthorized accounts at
Merrill Lynch and other small brokerages, Sumitomo reassigned
Hamanaka, who confessed to the manipulation scheme shortly
afterward. At this time, however, Hamanaka had yet to unwind
his futures and cash positions at the high market prices he had
created. Sumitomo also informed the CFTC of the losses Sumitomo
had incurred over the years as a result of Hamanaka's trading--
at the time it estimated those losses at $1.8 billion. It later
revised the estimate to $2.6 billion. Following Hamanaka's
reassignment and subsequent dismissal, copper prices dropped
nearly 30 percent--from $2,800 per metric ton to below $2,000
per metric ton.
---------------------------------------------------------------------------
\93\ Suzanne McGee and Stephen E. Frank, Metal Detection: Sumitomo
Debacle is Tied to Lax Controls by Firm, Regulators, Wall St. J., June
17, 1996. See also Kozinn, supra at 270-77.
---------------------------------------------------------------------------
Once Hamanaka's activities were disclosed, the CFTC again
requested information from the SIB regarding Sumitomo's
positions on the LME and the positions of U.S. affiliates on
the London exchange as well. According to former Chair Born,
``The SIB now recognized the seriousness of the situation and
became more responsive to the CFTC's information requests.
Nonetheless, there still remained some confusion and
disagreement about what information was relevant for regulatory
purposes and what information might be competitively
sensitive.'' \94\ The CFTC's subsequent investigation revealed
that Hamanaka had not only used the cash market for copper and
the LME to achieve his price manipulation, but had ``also used
OTC transactions in furtherance of its manipulative scheme,
both to obtain financing and to disguise the speculative nature
of its transactions.'' \95\
---------------------------------------------------------------------------
\94\ Born, supra at 623. In requesting information from the SIB,
the CFTC invoked the ``Boca Declaration,'' which had just been signed
in March 1996. The Boca Declaration, which was prompted by the collapse
of the Barings Bank due to unauthorized trading in derivatives by one
of its young employees, pledged the signatories to share information in
the event of a significant financial reversal by a member of an
exchange or clearing organization.
\95\ Id.
---------------------------------------------------------------------------
Because Sumitomo had sufficient assets to cover the entire
$2.6 billion loss, Sumitomo did not default on its obligations
and its losses did not trigger a chain-reaction of defaults or
require a take-over or bail-out. Nonetheless, according to the
former CFTC Chair, ``the impact of Sumitomo's activities on
world copper prices did have a profound economic impact both
within the United States and abroad. As the CFTC investigation
revealed, Sumitomo manipulated the price of copper in what may
well have been the most significant commodity price
manipulation since the Hunt brothers' manipulation of the world
market in silver in 1979 and 1980.'' \96\ One metals trader
estimated that Hamanaka's manipulation artificially raised the
price of copper an average of 5 cents per pound on the spot
market for 5 years, during which time copper was trading
between 73 cents and $1.46 per pound.\97\ This cost would have
been passed on to copper processors and manufacturers of copper
products, and ultimately, consumers.\98\
---------------------------------------------------------------------------
\96\ Id.
\97\ Strom, A Market Ripe for Manipulation; Laxity in London Opened
Door for a Sumitomo Trader, supra.
\98\ Some sophisticated market players, such as George Soros,
detected that copper prices were unusually high during Hamanaka's
manipulations and sold short large quantities of copper. Such
speculative short selling drove even more buying by Hamanaka to prop
prices up. Eventually, even Soros declined to continue to trade against
Hamanaka. Paul Krugman, How Copper Came a Cropper, The Dismal Science,
July 19, 1996.
---------------------------------------------------------------------------
Sumitomo acknowledged the activities of Hamanaka, but
claimed it had no knowledge of those activities at the time,
and stated that such activities were unauthorized. Sumitomo
settled with the CFTC by agreeing to cease and desist from
further violations of the anti-manipulation provisions of the
CEA, paying a $125 million civil penalty, and establishing a
$25 million escrow fund to pay restitution to persons injured
by Sumitomo's manipulative conduct. At the time, the civil
penalty imposed upon Sumitomo was the largest civil penalty
ever imposed by the U.S. Government. In Japan, Hamanaka was
found guilty of forgery and fraud, and sentenced to 8 years in
prison.
Subsequently, the CFTC found that Merrill Lynch had ``aided
and abetted'' Sumitomo by providing more than $500 million of
credit to Sumitomo, which Sumitomo used to purchase copper on
the cash market and LME futures contracts. The director of the
CFTC's enforcement division stated the case was ``one of the
most serious world-wide manipulations of a commodities market
encountered in the 25-year history of the commission.'' \99\
The CFTC complaint charged ``Merrill Lynch participated in the
manipulation as something it wished to bring about because
Merrill Lynch earned money as copper prices rose.'' \100\ It
further alleged that Merrill Lynch officials ``had correctly
concluded that Global and Sumitomo's warrant-taking operation
was motivated by their intention to manipulate prices and
spread, not by genuine commercial need, and that Global and
Sumitomo were attempting to manipulate, and were successfully
manipulating the world's copper markets.'' Although Merrill
Lynch initially denied any wrongdoing, it settled the CFTC's
suit by agreeing to a cease and desist order and paying a civil
monetary penalty of $15 million.
---------------------------------------------------------------------------
\99\ Charles Gasparino, CFTC Charges Merrill Lynch in Sumitomo
Copper Scandal, Wall Street Journal, May 21, 1999.
\100\ Id.
---------------------------------------------------------------------------
In 1999, Sumitomo filed suit against J.P. Morgan Chase for
its role in facilitating Hamanaka's manipulative scheme.
According to papers filed by Sumitomo in the lawsuit, J.P.
Morgan and its Morgan Guaranty Trust subsidiary sold
``esoteric'' derivatives to Sumitomo which, in reality, were no
more than disguised loans. Sumitomo claimed that J.P. Morgan
officials knew that Hamanaka was engaged in an illegal trading
scheme, but nonetheless provided him with $735 million in
credit so they could earn substantial fees and
commissions.\101\ In 2002, J.P. Morgan Chase agreed to pay $125
million to Sumitomo to settle the suit.\102\
---------------------------------------------------------------------------
\101\ Bank & Lender Liability Litigation Reporter, J.P. Morgan
Granted Relief in Sumitomo Case; Chase Not so Fortunate, November 30,
2000.
\102\ Bayan Rahman, J.P. Morgan Chase, Sumitomo Settle in Copper
Scandal, National Post (f/k/a The Financial Post), April 2, 2002.
---------------------------------------------------------------------------
A U.S. metals trading firm alleged to have conspired with
Sumitomo to manipulate copper prices, Global Minerals & Metals
Corp., has contested the CFTC's charge of manipulation. The
CFTC's enforcement proceedings against this company and several
of its employees are on-going, but have been delayed by
acrimonious pre-hearing disputes. In a ruling earlier this
year, a CFTC administrative law judge stated, ``From the
outset, this matter has been mired in pleading, document
production, and professional misconduct disputes. To date, this
case has generated a total of 13 CCH-reported opinions and
orders (this will be the 14th), without a hearing on the merits
of the Commission's complaint in sight.'' \103\ With respect to
the merits, the judge opined, ``[T]his proceeding raises a host
of highly complex and interesting issues of law, economics and
quantitative analysis for our consideration.'' \104\
---------------------------------------------------------------------------
\103\ In re Global Minerals & Metals Corp. et. al., 2002 CFTC LEXIS
12, at *5, Comm. Fut. L. Rep. (CCH) para. 28,916 (January 23, 2002).
\104\ Id. at 2.
---------------------------------------------------------------------------
The Sumitomo case demonstrates that even in a manipulation
case in which the principal participant has admitted guilt and
is serving an 8-year prison sentence for fraud and forgery, the
responsible corporation in the manipulative scheme has admitted
liability and paid $150 million in penalties, and two of the
investment firms that financed the scheme have paid an
equivalent amount, many obstacles impede proving, under current
case law, that alleged conspirators in the scheme manipulated
the market.
2. International Agreement to Address Problems Raised by Sumitomo
In the wake of the Sumitomo manipulation, regulators from
the three nations whose markets were principally affected by
the affair--the United States, United Kingdom, and Japan--
recognized the existing international understandings and
framework for obtaining and sharing information on commodity
trading were inadequate. Hamanaka had managed to evade
detection for as long as he did by operating in the London and
OTC markets, where there was much less transparency than on the
regulated U.S. exchanges. In addition, by using a mix of
international markets, he ensured that none of the various
market authorities with jurisdiction over Hamanaka's trading
activity was able to obtain a complete or accurate view of
their own markets or his activities. Following the incident,
CFTC Chair Born wrote, ``The Sumitomo incident had confirmed
that information sharing may be important to market oversight
and regulation even before any enforcement actions are
envisioned and that the information needed may involve the
state of the market as a whole as well as the situation of
particular market participants.'' \105\
---------------------------------------------------------------------------
\105\ Born, supra at 625.
---------------------------------------------------------------------------
The U.S., U.K., and Japanese regulators convened a meeting
of international commodity market regulators in London in
November 1996, to begin to develop a new international
agreement for the sharing of market information. ``The co-
sponsors believed that Sumitomo's manipulation of the copper
markets demonstrated that derivatives markets in international
commodities involving physical delivery, such as copper, posed
special regulatory issues and concerns, especially relating to
the availability of deliverable supplies and susceptibility to
market manipulation.'' \106\
---------------------------------------------------------------------------
\106\ Born, supra at 626.
---------------------------------------------------------------------------
The London meeting resulted in the issuance of the London
Communique on Supervision of Commodity Futures Markets, which
sought to address the international regulatory issues raised by
the Sumitomo manipulation. The London Communique ``recognized
that futures contracts based on an underlying physical
commodity--and particularly those requiring physical delivery--
pose particular concerns for market integrity and the
supervision of such markets.'' \107\ In issuing the Communique,
the regulators specifically agreed that better contract design,
more effective market oversight, and regulatory measures
designed to provide regulators with information on large
positions in cash and OTC markets should be adopted.
---------------------------------------------------------------------------
\107\ Id.
---------------------------------------------------------------------------
Specifically, the London Communique stated the following
with respect to physical commodity markets:
Proper contract design is critical to reducing
the susceptibility of such contracts to market abuses,
including manipulation, and is an important complement to an
appropriate market surveillance program.
An effective market surveillance program by the
market regulatory authorities is essential to ensure that
commodity futures markets operate in a fair and orderly manner;
and should be designed to detect, to prevent, to take
corrective action with respect to, and to punish abusive
conduct and should be supported by appropriate regulatory
measures.
Market authorities should have access to
necessary information.
Market authorities of related markets should
share surveillance information in order to manage market
disruption.
Regulatory measures which facilitate the
identification of large exposures should be developed. These
measures may involve access to information relating to the
persons holding or controlling large exposures and their
related derivatives, over-the counter and cash market
positions. These measures may also involve access to
information on deliveries.
Following the issuance of the London Communique,
international regulators continued to work to develop
appropriate standards of best practice and guidelines for the
design of contracts and market oversight programs. In October
1997, the regulators met again, this time in Tokyo, Japan. This
international meeting resulted in the issuance of the Tokyo
Communique on Supervision of Commodity Futures Markets, which
contained Guidance on Standards of Best Practice for the Design
and/or Review of Commodity Contracts; and Guidance on
Components of Market Surveillance and Information Sharing
(``Market Surveillance Guidance'').
The Market Surveillance Guidance recommends that regulators
routinely collect and analyze information regarding cash and
OTC markets related to regulated futures markets. The Guidance
states:
Each commodity futures market and other market
authorities should have a clear framework for conducting market
surveillance, compliance and enforcement activities and there
should be oversight of those activities.
Information should be collected on a routine and
non-routine basis for on-exchange and related cash and over-
the-counter (``OTC'') markets and should be designed to assess
whether the market is functioning properly. Market authorities
should have access to information that permits them to identify
concentrations of positions and the composition of the market.
It is acknowledged that data on related cash and OTC markets
may be less immediately available than data for exchange
markets. This may be an area which requires governmental
powers.
The Market Surveillance Guidance also stated that the
collection and analysis of market information should occur
``speedily''; effective emergency powers should be available to
intervene in the market to prevent or to address abusive
practices or disorderly conditions; effective power should be
available to discipline market members; the relevant authority
should have the power to address abusive actions by non-
members; and market authorities should cooperate to share
information, particularly on large exposures.
The 17 nations that participated in the Tokyo conference
also recommended the removal of domestic legal barriers to the
implementation of these recommendations:
Furthermore, in view of the fact that information is
a critical tool for maintaining fair and orderly
markets and ensuring market integrity in non-financial
physical delivery markets with finite supply, that
market authorities should seek the removal of domestic
legal or other barriers to ensure, consistent with the
regulatory framework of each jurisdiction, access by
market authorities to information that permits them to
detect and to deter abusive practices and disorderly
conditions in the markets, including access to
information that permits them to identify
concentrations of positions and the overall composition
of the market.
Former CFTC Chair Born summarized the significance of the
Tokyo Communique as follows:
The Guidances provide for the first time useful
international benchmarks for the supervision of
commodity derivatives markets and underscore the
importance of detecting and deterring manipulative
activities such as those engaged in by Sumitomo. The
consensus on the need for information concerning large
positions on exchange markets and related cash and OTC
markets was a significant step forward in enhancing the
international standards of regulation of these markets,
particularly in light of the participants' commitment
to work to alter their domestic laws in order to
implement the provision. Furthermore, the recognition
of the importance of sharing such information as part
of an international effort to detect broad-based
manipulation efforts in their incipiency represents
substantial progress toward protecting the integrity of
the global marketplace.\108\
---------------------------------------------------------------------------
\108\ Born, supra at 630.
Despite the commitments it made in the 1997 Tokyo
Communique, the United States has failed to increase its
oversight of or collection of information related to large
positions on OTC markets. To the contrary, as explained in
Appendix 2, in 2000, Congress enacted the Commodity Futures
Modernization Act (CFMA), which extended the unregulated status
of OTC markets for energy, metals, and financial derivatives.
Economic damage to U.S. consumers, business, and the California
and U.S. economies from fraud and possible price manipulation
in U.S. energy markets have renewed calls for increased
government oversight of energy contracts, swaps, and
derivatives. Legislation has been introduced, but not yet
enacted into law, to eliminate a number of the exclusions and
exemptions for energy contracts from the CEA that now limit the
Federal Government's ability to detect, deter, and punish
manipulation in U.S. energy markets.
APPENDIX 2
----------
HISTORY AND CURRENT STATUS OF COMMODITY MARKET REGULATION
In the United States, the Commodity Exchange Act (CEA) is
the primary Federal statute governing the purchase and sale of
contracts for the future delivery of crude oil. Section I of
this Appendix describes the legislative history and major
provisions of the CEA as it relates to the trading of contracts
for future delivery of crude oil. Section II describes the
recent exclusions and exemptions for energy and crude oil
contracts that are traded ``over-the-counter.''
I. LEGISLATIVE HISTORY OF THE COMMODITY EXCHANGE ACT
``[The CFTC] chairman, William Bagley, was fond of
reminding people that the CFTC had fewer `policemen'
than the Rockville, Maryland, Police Department--and
this to monitor the commodity exchanges that are among
the world's most complex economic institutions.''
--Dan Morgan, Merchants of Grain (1980)
Summary: A fundamental purpose of the regulation of the
commodities futures markets is to prevent manipulation.
A. Background on Commodities Exchanges and Need for Regulation
In 1848, as the industrial revolution was helping transform
the American Midwest into productive farmland, 82 merchants
founded the Chicago Board of Trade (CBOT) to be a central
marketplace for producers, buyers, and sellers in the expanding
grain trade. In 1865, the CBOT developed futures contracts for
trading on the exchange. These standardized contracts, which
provided for delivery of a standardized quantity of grain, at a
specific location, on a fixed date in the future, at an agreed-
upon price, afforded farmers with the price certainty and
stability that enabled them to commit resources to the planting
of wheat without knowing the specific prices the wheat would
eventually obtain on the spot market. Similarly, these futures
contracts allowed grain traders, processors, and merchandisers
to protect themselves or ``hedge'' against price volatility
while transporting, storing, and processing the grains. The
trading of futures contracts attracted speculators who were
willing to absorb some of these price risks in exchange for
speculative gains, bringing ``liquidity'' to the market. This
market innovation enabled American farmers and merchants to
join in the mushrooming international trade in grains in the
latter part of the 19th Century.
Hundreds of other agricultural exchanges soon sprouted
across the country to participate in the domestic and
international markets. In 1872 in New York, a group of dairy
merchants organized the ``Butter and Cheese Exchange of New
York,'' which also began trading in futures. The New York
exchange soon grew to become the ``Butter, Cheese and Egg
Exchange,'' and, in 1882, to reflect the inclusion trade of
poultry, groceries, dried fruits, and other produce, became
simply ``the New York Mercantile Exchange.''
Over time, most of the smaller exchanges could not compete
with the large exchanges in New York and Chicago, and have
either folded or been consolidated into the major exchanges.
The last major consolidation occurred in 1994, when the New
York Mercantile Exchange merged with the Commodity Exchange
(COMEX), which trades in items such as gold, copper, hides,
rubber, silk, silver, and tin. A list of commodity exchanges in
operation today is provided in Table A.2-1.\1\
---------------------------------------------------------------------------
\1\ CFTC website, at http:/www.cftc.gov/dea/deadcms--table.htm.
[GRAPHIC] [TIFF OMITTED] T5551.007
In the late 19th Century, the commodities markets were
self-regulated and rife with manipulation. To many, the
commodities markets did not reflect natural forces of supply
and demand or perform a valuable economic function, but rather
were corrupt institutions that enabled unscrupulous speculators
to control the price of basic commodities. ``[T]he frequent
picture of commodity exchanges was one of unbridled
speculation, recurrent market manipulations, and spectacular
price fluctuations. Indeed, it was a serious question with many
whether the economic services of the system in the 1870's and
1880's were not outweighed by speculative excesses and abuses
of the system.'' \2\ The ``shenanigans that took place year in
and year out at the Chicago Board of Trade'' fed into the
populist resentment against the trusts, banks, and other large
corporate interests toward the end of the century:
---------------------------------------------------------------------------
\2\ Report of the Senate Committee on Agriculture, Nutrition, and
Forestry, to accompany S. 2019, Futures Trading Act of 1982, S. Rept.
97-384, 97th Cong., 2nd Sess. 11 (1982).
The Board of Trade, which was created in 1848 at the
instigation of Chicago's merchants, soon became a sort
of international symbol of the worst elements of
American free enterprise: greed; the cycle of riches
and ruin, boom and bust; corruption. There was an orgy
of speculation and market manipulation during the Civil
War. The Board printed rules governing trading in 1869,
but abuses of all kinds continued--fraud, bribery of
telegraph operators to obtain confidential information
(until coded messages were used), and the spreading of
false rumors to influence prices. Outside the trading
floor at Jackson and La Salle streets, bucket shops,
not much different from bookie joints or other gambling
establishments, flourished.\3\
---------------------------------------------------------------------------
\3\ Dan Morgan, Merchants of Grain, at 95 (Penguin, 1980).
Most attempts at cornering the market did not succeed,
mainly because the markets were too large. ``Memoirs of the
markets are full of stories about attempted corners, and they
usually have two things in common: greed and failure.'' \4\
``Squeezes made some rich, and bankrupted others. The more
severe episodes placed enormous strains on the nation's
financial system. . . . Indeed, the gold corner shook the
administration of Ulysses S. Grant (who was indirectly linked
to the scheme) to its core and largely foreshadowed its litany
of scandal.'' \5\ The rampant corruption and manipulations
undermined confidence in the futures markets. ``The
irresponsible trading and lack of effective market regulation
in the early period stirred farm resentment and opposition to
futures trading that still exist to a limited extent.'' \6\
---------------------------------------------------------------------------
\4\ Stephen Fay, Beyond Greed, at 60 (1982).
\5\ Steven Craig Pirrong, The Economics, Law, and Public Policy of
Market Power Manipulation 2 (1996).
\6\ S. Rept. 97-384, supra at 11.
---------------------------------------------------------------------------
B. The Commodity Exchange Act
1. Grain Futures Act of 1922
``The abuses of futures trading in this early period
resulted in repeated efforts of various State legislatures,
from the late 1860's onward, to abolish futures trading.'' \7\
In 1892-93 both houses of Congress passed bills that would have
imposed a prohibitive tax on futures trading; final legislation
was narrowly defeated on a procedural motion.\8\ As farm prices
rose and stabilized in the ensuing years, however, legislative
efforts focused on regulation of the markets rather than their
abolition.
---------------------------------------------------------------------------
\7\ S. Rept. 97-384, supra at 11; Dan Morgan, Merchants of Grain,
at 97 (Penguin, 1980).
\8\ S. Rept. 97-384, supra at 11.
---------------------------------------------------------------------------
It was not until grain prices collapsed after the First
World War that Federal legislation was passed to regulate the
futures markets. During the First World War, the disruption of
European grain production and markets drove up prices for
American grain, providing handsome profits for entrepreneurial
merchants and speculators. After the War ended, the high levels
of production in the United States and the resumption of grain
production in Europe caused wheat prices to plummet. At the
same time, the overall U.S. economy had fallen into a
depression. American farmers blamed their post-war plight on
the excesses of the speculators, particularly the short
sellers, whose speculative selling, they believed, had driven
down the price of grains.\9\ At Congressional hearings, farm
witnesses ``attacked speculators as `predatory parasites,'
thieves, gamblers, and wealthy individuals who `live like lords
and ride in high-powered automobiles and live in great
residences.' '' \10\ The farmers clamored for either outright
abolition of the trading of futures or, at the very least,
stringent linkages between contracts for futures and the
physical market.\11\
---------------------------------------------------------------------------
\9\ See Romano, The Political Dynamics of Derivative Securities
Regulation, 14 Yale J. on Reg. 279, 287 (1997).
\10\ Id. at 292.
\11\ Id., at 291-294.
---------------------------------------------------------------------------
Largely as a result of the agitation from the farmers, in
1922, the Congress passed the Grain Futures Act to prevent
excessive speculation and manipulation.\12\ Congress set forth
in the statute itself the purpose of the futures markets--for
hedging, price discovery, and price dissemination; the
importance of these markets to the national and international
commerce; and the public interest in preventing excessive
speculation and manipulation:
---------------------------------------------------------------------------
\12\ The Future Trading Act, 42 Stat. 187 (1921), imposed a tax on
all grain futures contracts that were not traded on a designated
contract market. In Hill v. Wallace, 269 U.S. 44, 42 S.Ct. 453, 66
L.Ed. 822 (1922), the Supreme Court held this Act to be an
unconstitutional violation of the taxing power. To remedy this
constitutional defect, the next year the Congress passed the Grain
Futures Act, 42 Stat. 998 (1922), with virtually the same provisions as
the overturned law, but without the offending tax provision. The Grain
Futures Act simply made it illegal to trade in futures contracts off a
designated contract market. The Supreme Court upheld the Grain Futures
Act as a constitutional exercise of the power to regulate interstate
commerce in Board of Trade v. Olsen, 262 U.S. 1, 43 S.Ct. 479, 67 L.Ed.
839 (1923).
The prices involved in such transactions are
generally quoted and disseminated throughout the United
States and in foreign countries as a basis for
determining the prices to the producer and the consumer
of commodities and the products and byproducts thereof
and to facilitate the movements thereof in interstate
commerce. Such transactions are utilized by shippers,
dealers, millers, and others engaged in handling
commodities and the products and byproducts thereof in
interstate commerce as a means of hedging themselves
against possible loss through fluctuations in price.
The transactions and prices of commodities on such
boards of trade are susceptible to excessive
speculation and can be manipulated, controlled,
cornered or squeezed to the detriment of the producer
or the consumer and the persons handling commodities
and the products and byproducts thereof in interstate
commerce, rendering regulation imperative for the
protection of such commerce and the national public
interest therein.\13\
---------------------------------------------------------------------------
\13\ 7 U.S.C.A. Sec. 5 (1999).
The 1922 Act established much of the framework for the
regulation of the commodities exchanges in effect today. The
Act required all grain futures contracts to be traded on a
designated contract market,\14\ and authorized the Secretary of
Agriculture to designate a board of trade as a ``contract
market'' if the board satisfied a number of conditions set
forth in the statute. Among these conditions were for the board
of trade to require members of the exchange to keep records of
their transactions, to prevent ``false or misleading or
knowingly inaccurate reports concerning crop or market
information,'' and to prevent the ``manipulation of prices and
the cornering of any commodity.'' \15\ The Act provided the
government--a commission made up of the Secretary of
Agriculture, the Secretary of Commerce, and the Attorney
General--with the authority to revoke the designation of any
board that failed to comply with the conditions of its
designation as a contract market.
---------------------------------------------------------------------------
\14\ In making off-exchange transactions in futures illegal,
Congress intended to stop the ``bucketing'' of orders in ``bucket
shops.'' A ``bucket shop'' would take a customer order for a futures
transaction but not place the order on the exchange; as the counter-
party to the customer's transaction the bucket shop would attempt to
profit from price movements adverse to the customer. Bucket shops also
would offset orders from customers with opposing positions against each
other, thereby short-circuiting the open outcry price discovery
mechanism of the exchange. Both practices exposed the customers to
additional costs and risks of default. See, e.g., Markham, supra at
n139 and accompanying text.
\15\ 7 U.S.C.A. Sec. 7 (1999).
---------------------------------------------------------------------------
2. Commodity Exchange Act
In 1936, Congress enacted the Commodity Exchange Act (CEA)
to rename and expand the scope of the original Grain Futures
Act to include not only grain but various other commodities,
including cotton, butter, and eggs.\16\ The exchanges that
traded these commodities opposed the regulation of their
markets as unnecessary, and, in what became a typical objection
to the various proposed expansions of the markets regulated by
the CEA, predicted dire consequences if these markets were
regulated. Experience, however, proved such fears to be
unfounded.
---------------------------------------------------------------------------
\16\ 49 Stat. 1491 (1936).
---------------------------------------------------------------------------
Congress also strengthened the anti-manipulation provisions
of the Act. In response to the 1936 Supreme Court decision in
Wallace v. Cutten \17\, in which the Court held the Grain
Futures Act did not permit after-the-fact criminal prosecutions
for violations of the anti-manipulation provisions, Congress
made manipulation a misdemeanor punishable by a fine of $10,000
and imprisonment of up to 1 year. \18\
---------------------------------------------------------------------------
\17\ 298 U.S. 229 (1936).
\18\ 49 Stat. 1498, 1499 (1936)
---------------------------------------------------------------------------
Butter & Eggs and Cotton Exchanges Opposed
Regulation under the CEA
Although farmers and dairy producers supported the
regulation of butter and egg futures, the butter and
egg exchanges opposed it. Romano, supra. The President
of the Chicago Mercantile Exchange testified the
legislation was not needed to ``insure the free flow of
butter and eggs from the farm to the table of the
consumer.'' The President of the New York Mercantile
Exchange predicted the bill would ``undoubtedly curtail
trading in futures to such an extent that future boards
on commodity exchanges handling butter and eggs will
practically become useless.'' The exchanges requested
further study before legislation was enacted. Hearings
before the Senate Committee on Agriculture and
Forestry, To Amend the Grain Futures Act, 74th Cong.,
2nd Sess., April 21, 22, and 23 (1936).
Phelan Beale, General Counsel for the Cotton
Exchange, testified ``it would be a grievous error to
include cotton in a bill that primarily was drawn to
apply to grain.'' He asked the Committee to further
study the issue so that ``through no inadvertence nor
sins of omission or commission may the greatest
commodity in the United States and the greatest export
of the United States be impaired.'' Hearings before the
House Committee on Agriculture, Regulation of Commodity
Exchanges, 74th Cong., 1st Sess., 45-46, February 5, 7,
and 8, 1935.
The Congress also added an anti-fraud provision, which to
this date has remained essentially unchanged. \19\
---------------------------------------------------------------------------
\19\ 7 U.S.C.A. Sec. 6b (1999).
---------------------------------------------------------------------------
The CEA Anti-Fraud Provision
Section 4b of the CEA makes it unlawful for any
person, in connection with the sale of or order for any
contract for future delivery that is used for hedging,
price discovery, or actual delivery of such commodity,
to: (i) cheat or defraud, or attempt to cheat or
defraud, another person; (ii) willfully make any false
statement to another person or create a false record;
(iii) willfully deceive or attempt to deceive another
person; or (iv) to bucket any such orders, offset such
orders against orders of other persons, or willfully
and knowingly become the buyer or seller of sell or buy
orders without the consent of the other party.
3. 1968 Amendments
In 1968, Congress again expanded the Act and strengthened
the anti-manipulation and anti-fraud provisions.\20\ The 1968
amendments brought several additional commodities, such as live
cattle and pork bellies, within the scope of the Act. It
empowered the Secretary of Agriculture to disapprove rules
adopted by a contract market that would violate the Act or the
regulations established thereunder, and also required the
contract markets to enforce all of its rules that were not
disapproved by the Secretary of Agriculture. The amendments
made a violation of the anti-manipulation and anti-fraud
provisions a felony rather than a misdemeanor, with a maximum
prison term of 5 years.
---------------------------------------------------------------------------
\20\ 82 Stat. 26 (1968).
---------------------------------------------------------------------------
4. 1974 Amendments: Creation of CFTC
Initially, jurisdiction over the commodities markets was
provided to the Department of Agriculture because the
commodities markets were centered around a limited number of
agricultural products. By the 1970's, a number of futures
markets in other products had developed, such as coffee, sugar,
cocoa, lumber, and plywood, plus various metals, including the
volatile silver market, and foreign currencies. In 1974,
Congress concluded the need to regulate these commodity markets
was no less than the need to regulate the agricultural markets
already within the Act:
A person trading in one of the then unregulated
futures markets needed the same protection afforded to
those trading in the regulated markets. Whether a
commodity was grown, mined, or created, or whether it
was produced in the United States or outside the United
States made little difference to those in this country
who bought, sold, processed, or used the commodity, or
to the United States consumers whose prices were
affected by the futures market in that commodity.\21\
---------------------------------------------------------------------------
\21\ S. Rept. 97-384, supra at 13.
Accordingly, Congress overhauled the CEA and expanded its
coverage to include a broad range of futures contracts, not
just the agricultural commodities already specified in the
statute.\22\
---------------------------------------------------------------------------
\22\ The commodities listed in the statute are wheat, cotton, rice,
corn, oats, barley, rye, flaxseed, grain sorghums, mill feeds, butter,
eggs, Solanum tuberosum (Irish potatoes), wool, wool tops, fats and
oils (including lard, tallow, cottonseed oil, peanut oil, soybean oil,
and all other fats and oils), cottonseed meal, cottonseed, peanuts,
soybeans, soybean meal, livestock, livestock products, and frozen
concentrated orange juice. 7 U.S.C.A. Sec. 1a(4) (West Supp. 2002). In
1958, as a result of the numerous manipulations of the onion market,
the Congress prohibited all futures in onions. Pub. L. 85-839, Sec. 1,
Aug. 28, 1958, 72 Stat. 1013; 7 U.S.C.A. Sec. 13-1 (West 1999). See
Markham, supra at 318 (``Perhaps the most manipulated market of all was
onions.'').
---------------------------------------------------------------------------
Coffee & Sugar and Cocoa Exchanges and Silver
Companies Opposed Regulation Under the CEA
The New York Coffee and Sugar Exchange and the New
York Cocoa Exchange (both are now part of the New York
Board of Trade) opposed the regulation of their
markets. One representative testified these exchanges
were ``more than adequately regulated'' under their own
rules and the ``good sound judgment'' of their officers
and governing boards. He perceived ``no reason'' for
regulation under the CEA. The exchanges predicted that
regulation would drive these futures markets overseas,
causing the United States and the City of New York ``to
lose substantial employment opportunities and taxable
revenues,'' and ``would increase the volatility of
commodity prices passed on to consumers in the United
States.'' Commodity Futures Trading Commission Act,
Hearings before the Senate Committee on Agriculture and
Forestry, 93rd Cong., 2nd Sess, Pt. 2, 464, 465 (1974).
Today, the New York Board of Trade states it is ``the
world's premier futures and options markets'' for
cocoa, coffee, cotton, frozen concentrated orange
juice, and sugar. New York Board of Trade, Agricultural
Futures & Options.
Several companies trading in silver opposed the
regulation of futures contracts for silver. Even as the
Hunt brothers were active in the silver market, the
Chairman of Mocatta Metals, the largest U.S. silver
bullion dealer, testified there were ``no major
scandals or improprieties affecting trading on the
major international commodity exchanges necessitating
emergency amelioration,'' and urged more study of the
issue. Mocatta predicted full CFTC regulation ``could
upset the markets for international commodities and
materially reduce the vitality of U.S. participation in
those markets, thereby causing those commodities to
flow away from our shores and to be most costly to
acquire for consumption in the U.S.'' 1974 Senate
Hearings, supra, at Part. 3, 797 (Statement of Dr.
Henry G. Jarecki).
The 1974 Amendments expanded the Act to include ``all other
goods and articles . . . and all services, rights, and
interests in which contracts for future delivery are presently
or in the future dealt in.''
In expanding the scope of the Act, Congress reiterated the
purpose of the Act to prevent fraud, manipulation, and control
speculation in the commodity markets:
The fundamental purpose of the Commodity Exchange Act
is to ensure fair practice and honest dealing on the
commodity exchange and to provide a measure of control
over those forms of speculative activity which too
often demoralize markets to the injury of producers and
consumers and the exchanges themselves.\23\
---------------------------------------------------------------------------
\23\ S. Rept. 93-1131, 93rd Cong., 2nd Sess. (1974).
The legislation transferred the authority of the Secretary
of Agriculture to the new Commodity Futures Trading Commission
(CFTC), an independent five-member regulatory agency. The 1974
Amendments increased the maximum fine for a violation of the
anti-manipulation prohibition from $10,000 to $100,000.\24\
---------------------------------------------------------------------------
\24\ Pub. L. 93-463, Sec. 212(d)(1) (1974). In 1978, Congress
increased the maximum financial penalty for manipulation to $500,000,
Pub. L. 95-405, Sec. 19(1). The maximum penalty was increased to
$1,000,000 in 1992. Pub. L. 102-546 Sec. 212(a).
---------------------------------------------------------------------------
Congress also clarified that this expansion of CEA coverage
did not extend to certain financial transactions. During the
debate over the 1974 amendments, the Treasury Department had
expressed concern that the proposed language to broaden the Act
could be read to encompass the existing trade in currency
futures between large banks and other sophisticated
institutions. Congress responded by enacting the ``Treasury
Amendment,'' which exempted from the Act ``transactions in
foreign currency, security warrants, security rights, resales
of installment loan contracts, repurchase options, government
securities, or mortgages and mortgage purchase commitments,
unless such transactions involve the sale thereof for future
delivery conducted on a board of trade.'' \25\
---------------------------------------------------------------------------
\25\ 7 U.S.C.A. Sec. 2(i) (1999).
---------------------------------------------------------------------------
The Senate report on the 1974 legislation explained the
rationale underlying the Treasury Amendment:
[T]he Committee included an amendment to clarify that
the provisions of the bill are not applicable to
trading in foreign currencies and certain enumerated
financial instruments unless such trading is conducted
on a formally organized futures exchange. A great deal
of the trading in foreign currency in the United States
is carried out through an informal network of banks and
tellers. The Committee believes that this market is
more properly supervised by the bank regulatory
agencies and that, therefore, regulation under this
legislation is unnecessary.\26\
---------------------------------------------------------------------------
\26\ S. Rept. 93-1131 (1974).
In the mid-1970's, following the extreme price volatility
in the energy sector resulting from the Arab oil embargo, a new
market for energy futures emerged. In 1978, NYMEX offered
futures contracts in heating oil, and over the next several
years NYMEX proposed a variety of futures contracts in other
petroleum products. In 1983, NYMEX began trading in the WTI
futures contract.\27\
---------------------------------------------------------------------------
\27\ See John Elting Treat, ed., Energy Futures, Trading
Opportunities for the 1990's, 20-23 (1990).
---------------------------------------------------------------------------
Today, the vast majority of futures contracts traded on the
exchange are unrelated to agriculture. Whereas as recently as
the early 1970's, most of the approximately 13 million futures
contracts traded annually on domestic boards of trade involved
agricultural commodities, in 1999, nearly 600 million futures
contracts were traded annually in the United States, but with
only a small fraction--about 11 percent--related to
agriculture.\28\
---------------------------------------------------------------------------
\28\ Chicago Board of Trade, Action in the Marketplace, at 2.
---------------------------------------------------------------------------
In 1980, in a case involving the question of whether the
CEA provided a private right of action, the U.S. Court of
Appeals for the Second Circuit traced the history of the CEA
and observed how the Act had been strengthened over the years
to match the needs of the evolving futures markets:
The history of congressional concern with commodity
futures trading has thus been one of steady expansion
in coverage and strengthening of regulation. In 1936,
1968, and 1974 new commodities came under the CEA. In
each of these years the power of the regulatory
authority were augmented, and penalties were either
extended, increased, or both. The question of
Congressional intent with respect to private sanctions
under the Act must be considered against this
background of increasingly strong regulation designed
to insure the existence of fair and orderly
markets.\29\
---------------------------------------------------------------------------
\29\ Leist v. Simplot, 638.F.2d 283, 296 (2d Cir. 1980), aff'd sub
nom. Merrill Lynch, Pierce, Fenner & Smith v. Curran, 456 U.S. 353
(1982).
Although one of the main purposes of the CEA was to
discourage and punish market manipulation, manipulations and
attempts at manipulation of the commodity markets have
continued. In 1982, following the Hunt brothers' attempts to
---------------------------------------------------------------------------
corner the silver market, one observer commented:
The 19th Century grain market in Chicago was littered
with examples of attempted squeezes and corners; to a
lesser extent it still is. Rings and corners in the
stock market ended with the Great Crash and the
establishment of the Securities and Exchange Commission
in 1934. But commodities remained a temptation to the
corner men. In the last generation corners were
attempted in eggs, onions, vegetable oil, soybeans, and
potatoes. The fact that market manipulation is now
illegal does not stop people trying.\30\
---------------------------------------------------------------------------
\30\ Stephen Fay, Beyond Greed, at 60 (1982). For a list of Federal
manipulation cases decided between 1940 and 1989, see Markham,
Manipulation of Commodity Futures Prices--The Unprosecutable Crime, 8
Yale J. on Reg. 281 (1991) (``The commodity futures market has been
beset by large-scale manipulations since its beginning.'')
More recent history demonstrates that manipulations are not
``simply relics of the distant past.'' \31\ Allegedly, the Hunt
brothers squeezed the soybean market in 1977, as well as the
silver market a couple of years later. The Feruzzis allegedly
squeezed the CBOT soybean market in the late 1980's. ``In 1991,
the eminent investment bank and primary government securities
dealer Salomon Brothers successfully cornered several issues of
Treasury notes, thereby causing huge disruptions in the world's
financial market and throwing a cloud of suspicion over it that
has yet to dissipate completely.'' \32\ As discussed in
Appendix 1, the Sumitomo Corporation manipulated the price of
copper in the mid-1990's, causing as much as a 30 percent rise
in copper prices. And as discussed in the main section of this
report, in 2000, a U.S. refiner obtained a large financial
settlement from Arcadia, a crude oil trading company, in a
lawsuit over alleged manipulation of the crude oil market.
---------------------------------------------------------------------------
\31\ Steven Craig Pirrong, The Economics, Law, and Public Policy of
Market Power Manipulation (1996) at 3.
\32\ Id. See also Nicholas Dunbar, Inventing Money 109-112 (2001).
II. OVER-THE-COUNTER ENERGY DERIVATIVES: EXCLUSIONS AND EXEMPTIONS
FROM COMMODITY EXCHANGE ACT
``With the CFTC's withdrawal from regulating many of
the more popular derivatives in the late 1980's and
early 1990's, it appeared that dealers in those
financial products had found a virtually regulation-
free promised land.''
--Philip McBride Johnson, former Chairman, CFTC
(1999)
The CEA provides the CFTC with jurisdiction over
``agreements . . . and transactions involving contracts of sale
of a commodity for future delivery traded or executed on a
contract market . . . or any other board of trade, exchange, or
market.'' Neither the original Grain Futures Act of 1922, nor
any of the subsequent amendments, defined or set forth the
elements of a ``futures contract'' or the term ``future
delivery.'' Rather, the term ``future delivery'' is defined
only in reference to that which it is not--a ``forward
contract.'' The CEA's definition of ``future delivery'' merely
states: ``The term `future delivery' does not include any sale
of any cash commodity for deferred shipment or delivery.'' \33\
---------------------------------------------------------------------------
\33\ 7 U.S.C.A. Sec. 1a(19) (Supp. 2002).
---------------------------------------------------------------------------
The distinctions between ``future contracts,'' or
``contracts for future delivery,'' and ``forward contracts''
have never been settled. A key issue that arose after the 1974
expansion of the CEA and the enactment of the Treasury
amendment was the extent to which the swaps and other over-the-
counter derivatives that were coming into widespread use in the
1980's could be considered contracts for future delivery within
the scope of the CEA. Many of the OTC derivatives, such as
swaps, call for one or both parties to make a stream of
payments to the other party over a specified period of time. If
these OTC derivatives were to fall within the definition of a
contract for future delivery, then they would have become
legally suspect because they were not being traded on an
approved exchange. In the 1980's, as large corporations and
financial institutions increasingly used OTC derivatives to
manage financial risks, the uncertainty of the legal status of
these instruments became a significant concern. From then to
the present, the CFTC, other Federal agencies with jurisdiction
over financial instruments, the financial community, the oil
industry, other commodity traders, and Congress have debated
the extent to which these instruments should be regulated under
the CEA.
A. 1989 Swaps Policy Statement: Exemption for Certain OTC Swap
Transactions
In 1989, in response to the call for more legal certainty,
the CFTC issued a ``Swaps Policy Statement'' to clarify that it
would not seek to regulate certain OTC swap transactions.\34\ A
swap transaction is essentially ``an agreement between two
parties to exchange a series of cash flows measured by
different interest rates, exchange rates, or prices with
payments calculated by reference to a principal base (notional
amount).'' \35\ Financial swaps are used by corporations and
financial institutions to hedge exposure to changing interest
or currency exchange rates, or, on the other side of such a
transaction, to speculate on interest or currency exchange
rates. Commodity swaps are structured similarly to interest
rate or currency swaps, except that payments are calculated in
reference to the price of a specified commodity, such as crude
oil.
---------------------------------------------------------------------------
\34\ 54 Fed. Reg. 30,694 (1989).
\35\ Id.
---------------------------------------------------------------------------
In its 1989 Swaps Policy Statement, the CFTC held that
although swap transactions had elements of futures contracts,
most swap transactions were sufficiently distinguishable from
futures contracts to conclude they were ``not appropriately
regulated as such under the Act and its regulations.'' The CFTC
set forth a number of criteria a swap transaction must meet to
qualify for this exemption from regulation: (1) the swap
agreement must not be fully standardized, meaning the terms
must be negotiated by the parties and their terms must be
``individually tailored;'' (2) the swap agreement may not be
terminated through an exchange-style offset with other swap
agreements of opposite positions, and may be terminated only
with the consent of the counterparty; (3) the swap agreement
cannot be supported by the credit of a clearing organization,
as futures contracts are supported on an exchange, and each
party to the agreement must assume the credit risk of the other
party; (4) the transaction must be undertaken in conjunction
with a line of business, such as that conducted by a large
corporation, commercial or investment bank, insurance company,
or governmental entity; and (5) the swap transactions sought to
be exempted may not be marketed to the public.
The 1989 Swaps Policy Statement, however, did not end the
debate over the status of these types of contracts. The CFTC
did not declare in its policy statement that swap transactions
were excluded from regulation under the CEA; it only stated the
CFTC had chosen not to regulate them ``at this time.'' The
CFTC's action left open the possibility that swap transactions
could be regulated at some time in the future. This concern was
heightened the very next year, when controversy erupted over
the applicability of the CEA to the Brent market.
B. Exemptions for Certain Brent Crude Oil Contracts
1. The Transnor Decision
In April 1990, Judge William Conner, U.S. District Judge
for the Southern District of New York, ruling on a motion for
summary judgment in the case of Transnor v. BP,\36\ held that
15-day Brent contracts were future contracts within the meaning
of the CEA. As explained in more detail in Section III of the
main report, these contracts provide for the delivery of a
cargo of Brent crude oil, fully loaded at the Sullom Voe
terminal in the North Sea, at a specified month in the future.
They are used for hedging, price discovery, and speculation, as
well as for physical delivery of crude oil.
---------------------------------------------------------------------------
\36\ 738 F. Supp. 1472 (S.D.N.Y. 1990).
---------------------------------------------------------------------------
In Transnor, the plaintiff, a Bermuda-based oil trading
company, alleged that several North Sea oil producers--BP,
Shell, Conoco, and Exxon--had conspired to sell Brent crude oil
at below-market prices in order to lower the tax imposed on
their Brent production.\37\ In December 1985, Transnor
purchased, at an average price of $24.50 per barrel, two 15-day
Brent contracts for the delivery of two Brent cargoes (500,000
barrels per cargo) in March 1986. In early 1986, an OPEC price
war erupted, and the price of crude oil plummeted. By the end
of March, the price of Brent had fallen to $13.80 per barrel.
Transnor refused to take delivery of the crude oil and filed
suit against the four producers of Brent crude for $230 million
in damages, claiming that they were partially responsible for
the fall in price. Transnor alleged the Brent producers
conspired to fix prices, in violation of the Sherman Antitrust
Act, and manipulated the price of 15-day Brent contracts, in
violation of the CEA.
---------------------------------------------------------------------------
\37\ Shell and BP settled with Transnor and were dismissed from the
case. Shortly after filing suit, Transnor's oil trading operations went
bankrupt.
---------------------------------------------------------------------------
In his ruling, Judge Conner first addressed the question of
whether principles of comity and international law compelled
the court to decline to exercise jurisdiction. The judge found
that although the British government had expressed an intention
to promulgate some binding regulations applicable to the Brent
market, it had not actually issued any. The court concluded
``application of U.S. antitrust and commodity laws does not
create either an actual or potential conflict with existing
British government regulation of Brent market transactions.
That a conflict may arise in the future should the British
government act is too uncertain to weigh against the exercise
of jurisdiction.'' \38\ The court went on to find that the
parties' ties to the United States were ``stronger than those
to the United Kingdom,'' the alleged conduct ``clearly impacted
U.S. commerce,'' there were ``issues of fact as to whether
defendants intended to affect U.S. commerce or should
reasonably have foreseen such an impact,'' and ``the U.S. is an
important locus, if not the hub, of defendants' alleged
manipulation.'' \39\ In sum, the court held, ``with all factors
considered, both a quantitative and a qualitative tally favor
the exercise of jurisdiction by this Court--a result which
should not affront British interests.'' \40\
---------------------------------------------------------------------------
\38\ 738 F.Supp. at 1477.
\39\ Id. at 1477-1478.
\40\ Id.
---------------------------------------------------------------------------
After rejecting the defendants' arguments to dismiss the
plaintiff's antitrust claims, the court turned to the
defendants' contention that 15-day Brent contracts were in
reality ``contracts of sale of a commodity for future
delivery''--i.e., forward contracts--and therefore not within
the scope of the CEA. In analyzing this claim, the court first
reviewed the administrative and case law on the differences
between futures contracts and forward contracts, and then
examined the nature of the 15-day Brent market.
``Once distinguished by unique features, futures and
forwards contracts have begun to share certain characteristics
due to increasingly complex and dynamic commercial realities,''
the court stated. ``The predominant distinction between the two
remains the intention of the parties and the overall effect of
the transaction.'' In forward contracts, delivery of a physical
commodity occurs, but is delayed or deferred for convenience or
necessity.\41\ ``By contrast, futures contracts are undertaken
primarily to assume or shift price risk without transferring
the underlying commodity. As a result, futures contracts
providing for delivery may be satisfied either by delivery or
offset.'' \42\ In determining whether physical delivery is, in
fact, intended, the courts and the CFTC look both to the terms
of the contract and to the practices of the parties.\43\
---------------------------------------------------------------------------
\41\ The leading appellate case discussing these distinctions is
Commodity Futures Trading Comm. v. Co Petro Marketing Group, Inc., 680
F.2d 573(9th Cir. 1982).
\42\ Transnor, 738 F.Supp. at 1489.
\43\ Judge Conner also stated that language in an agreement
requiring future delivery of the underlying commodity does not mandate
the classification of the agreement as a forward contract, if the
delivery requirement is not expected to be enforced. ``This Court
concludes that even where there is no `right' of offset, the
`opportunity' to offset and a tacit expectation and common practice of
offsetting suffices to deem the transaction a futures contract.'' Id.
at 1492.
---------------------------------------------------------------------------
In examining the 15-day Brent contract, the Transnor court
found it had elements of both a futures contract and a forward
contract. The court concluded that although the 15-day Brent
contract embodied a binding commitment to buy or sell crude
oil, physical delivery was not generally contemplated by the
parties, and occurred only in a minority of transactions in the
15-day market. Thus, the court held the 15-day contracts were
not forward contracts:
Moreover, the high degree of standardization of terms
such as quantity, grade, delivery terms, currency of
payment and unit of measure, which facilitate offset,
bookout and other clearing techniques available on the
Brent market, further evidence the investment purpose
of Brent trading. The 15-day Brent market does not
remotely resemble the commercial trading originally
exempted from the Act. While this Court recognizes that
commercial transactions have increased in complexity
since the predecessor to the CEA was enacted, the
interests of Brent participants, which include
investment and brokerage houses, do not parallel those
of the farmer who sold grain or the elevator operator
who bought it for deferred delivery, so that each could
benefit from a guaranteed price.\44\
---------------------------------------------------------------------------
\44\ Id. at 1491.
The court then concluded the 15-day Brent contracts were
---------------------------------------------------------------------------
futures contracts covered by the CEA:
Most importantly, the Brent contracts were undertaken
mainly to assume or shift price risk without
transferring the underlying commodity. Defendants
acknowledge that the volume of Brent contract trading
greatly exceeded the amount of physical oil available
to satisfy such contracts. The volume of contracts
traded and the high standardization of the contracts
demonstrate the essential investment character of the
15-day Brent market. ``With an eye toward [their]
underlying purpose,'' the Court concludes that
Transnor's 15-day Brent transactions constitute futures
contracts.\45\
---------------------------------------------------------------------------
\45\ Id. at 1492.
With respect to Transnor's assertions, the court found
there were issues of material fact, and denied the motion for
summary judgment.\46\
---------------------------------------------------------------------------
\46\ The remaining defendants, Conoco and Exxon, settled
approximately 1 month later. The terms of the settlement were sealed.
Platt's Oilgram News, Brent 15-Day Market Case Settled; Terms Expected
to be Sealed, Say Lawyers, May 23, 1990. The New York Times, Suit on
Price of Crude Oil is Settled, May 23, 1990.
---------------------------------------------------------------------------
2. Industry Response to Transnor
The Transnor decision opened up a can of worms for oil
companies and traders in the Brent market--whether the CFTC
would begin to regulate the hitherto unregulated 15-day Brent
market, and whether the Brent contracts were legally invalid
under the CEA because they had not been traded on an approved
exchange. NYMEX President Patrick Thompson reflected the
market's worry over the ruling, stating the Transnor decision
``creates a concern that these are off-exchange futures
contracts, which are illegal under Section 4(a) of the
Commodity Exchange Act. If this holding stands, the 15-day
Brent market would have to be discontinued in the U.S.'' \47\
---------------------------------------------------------------------------
\47\ Platt's Oilgram News, NYMEX President Warns Forward Market
Players of Risk From Transnor Ruling, May 15, 1990. Thompson stated
NYMEX would support a clarification by the CFTC that provided an
exclusion from regulation of the 15-day Brent market for ``true
commercial interests.''
---------------------------------------------------------------------------
At the time the Transnor decision was issued, the CEA did
not provide the CFTC with any flexibility as to how futures
contracts were to be regulated. Under the CEA as it then
existed, once an instrument was determined to be a futures
contract, it was required to be traded on an approved exchange
in accordance with all of the rules and regulations regarding
exchange-traded contracts, or else be considered illegal. As
the Transnor decision highlighted, this ``all or nothing''
regulatory scheme, which had existed since the original Act was
passed in 1922, may have been adequate to deal with
conventional contracts for the sale or delivery of agricultural
commodities, but it did not provide any flexibility as to how
to best deal with the swaps, derivatives, hybrids, and other
novel financial instruments that had developed since the early
1980's.
The participants in the Brent market reacted swiftly.
Several major oil companies and traders, including Shell,
stopped trading 15-day Brent contracts with American firms;
others, such as Exxon, suspended all trading in 15-day Brent
contracts.\48\ ``The Transnor case has scared Brent's
traders,'' reported The Economist. ``Many have quit the Brent
market altogether, hedging instead on America's NYMEX and
London's International Petroleum Exchange, the two big official
oil-futures exchanges.'' \49\
---------------------------------------------------------------------------
\48\ Platts Oilgram Price Report, Basin Users Turn to ARCO Portion,
May 2, 1990; Steven Butler, Nervous Trading in a Market Held in Limbo,
Financial Times (London), May 3, 1990.
\49\ The Economist, Oil Trading; Brent Blues, April 28, 1990.
Because of the lack of transparency of the Brent physical market, it is
not possible to determine with any degree of accuracy just how much the
market was affected by the Transnor decision. One British publication
reported that by the time the Transnor case was settled, about six
weeks after the ruling, the 15-day Brent market had lost ``at least two
thirds of its liquidity.'' Larry Black, The Independent (London), Firms
in Brent Oil Trial Agree to Settle Out of Court, May 23, 1990. In his
dissent from the CFTC's subsequent decision to exempt 15-day Brent
contracts from regulation, Commissioner West quoted from several
articles by Petroleum Argus, a leading price reporting service, that
despite the Transnor decision Brent trading in April 1990 was higher
than in April 1989 and not much lower than in April 1988, and that
Brent trading had been steadily increasing since June 1990. CFTC,
Statutory Interpretation Concerning Forward Transactions, Dissent of
Commissioner West, Commodity Futures Law Reports, Commerce Clearing
House para. 24,925 (October, 1990).
---------------------------------------------------------------------------
Within days of Judge Conner's decision, lobbyists descended
upon the CFTC, seeking to mitigate the ruling.\50\ ``What the
CFTC will do next is uncertain,'' an article in Platts stated,
``but the lobbyists reportedly were urging the CFTC to state
that it will not regulate the 15-day Brent market. One source
said the judge's ruling did not mandate that the CFTC regulate
Brent trade. Instead, it stated only that Brent trade was not
`forward' trading as defined by the Commodities Exchange Act,
but instead is `futures' trading.'' \51\
---------------------------------------------------------------------------
\50\ Platts Oilgram Price Report, Companies Still Sorting Transnor
Impact; Brent Market Liquidity Impacted, April 24, 1990.
\51\ Id.
---------------------------------------------------------------------------
The British government promptly weighed in against the
Transnor decision too. In a letter sent to the CFTC less than 2
weeks after the decision, Britain's Department of Trade and
Industry (DTI) stated that the decision could be interpreted to
mean that all trading in 15-day Brent contracts, even such
trading between British persons within British territory, was
subject to the U.S. commodities laws. This interpretation,
according to the DTI, was ``in the British government's view,
contrary to international law and damaging to the British
national interest.'' The DTI expressed particular concern that
trades of 15-day Brent contracts within the United Kingdom
could be declared illegal or void in the United States. The DTI
proposed an urgent meeting with the CFTC to resolve the
issue.\52\
---------------------------------------------------------------------------
\52\ Platts Oilgram News, UK Agency Expresses Concern Over Conner
Ruling on Brent Trading, May 2, 1990; The Financial Times (London),
Britain Challenges US Jurisdiction Claim over Brent Crude Oil Market,
May 2, 1990.
---------------------------------------------------------------------------
In response to the concern over the Transnor decision, the
CFTC immediately began ``an examination'' of the Brent
issue.\53\ ``The probe appears to be triggered as much by
pressure from Brent market participants as by Conner's
ruling,'' Platts reported.
---------------------------------------------------------------------------
\53\ Robert Di Nardo, Platts Oilgram Price Report, CFTC Begins
Study of Brent Market Trading, April 25, 1990.
---------------------------------------------------------------------------
Seven days after the Transnor decision, the CFTC announced
it was ``considering actions appropriate to maintain United
States commercial access'' to the Brent market and committed
itself to act ``as expeditiously as possible.'' \54\ According
to Platts, ``The CFTC issued its advisory in response to calls
from Brent players who have been uncertain whether they can
continue to trade paper Brent from the US after a ruling by a
Federal district court last week . . . that the Brent 15-day
contract is a futures contract.'' \55\
---------------------------------------------------------------------------
\54\ CFTC Advisory No. 31-90, April 25, 1990; Platts Oilgram Price
Report, CFTC Looking to Act Quickly on Brent Market, April 26, 1990.
\55\ Id.
---------------------------------------------------------------------------
3. LCFTC: 15-Day Brent Contracts are Forward Contracts
In response to the concerns of oil companies and traders,
financial institutions, and the British government, CFTC
Chairwoman Wendy Gramm quickly concluded the CFTC should not
assert authority over the Brent market. In a speech to the
Futures Industry Institute on May 2, 1990, Chairwoman Gramm
``indicated aversion to regulating the 15-day Brent market,''
stating it is ``not true that any instrument with a bit of
futurity is a futures contract and therefore within the CFTC's
jurisdiction.'' \56\
---------------------------------------------------------------------------
\56\ Platt's Oilgram Price Report, Gramm Speaks Out on Brent
Regulation, May 3, 1990.
---------------------------------------------------------------------------
Shortly afterwards, in mid-May, the CFTC reaffirmed that
position. The CFTC and the British Department of Trade and
Industry issued a joint release stating, ``The Brent market is
an international market and cannot be regarded as or regulated
as if it were exclusively a U.S. market.'' \57\ Concurrently,
the CFTC staff sent a letter to the companies that had
contacted the CFTC on the Transnor decision, stating:
---------------------------------------------------------------------------
\57\ CFTC New Release No. 3248-90, May 16, 1990; Hattie A. Wicks,
The Oil Daily, U.S., British Agencies Reject Plans to Regulate Brent
Forward Market, May 17, 1990.
As represented to the staff, it is our understanding
that the market in 15-day Brent contracts among other
things involves negotiated transactions between
commercial parties, each of whom has the capacity to
make or take delivery of Brent crude oil. These
contracts are not offered or sold to the general
public. Based on these representations the Task Force
is of the view that these contracts fall within the
category of transactions encompassed by the so-called
forward contract exclusion.\58\
---------------------------------------------------------------------------
\58\ The Oil Daily, CFTC Outlines its View of Brent Trade, May 17,
1990.
The letter went on to say that the CFTC likely would issue
a formal interpretation of the CEA consistent with this view,
and, in the meantime, ``the staff will not recommend to the
Commission any enforcement action under the Commodity Exchange
Act or regulations thereunder based solely upon the activity of
engaging in transactions involving such contracts.'' \59\
---------------------------------------------------------------------------
\59\ Id.
---------------------------------------------------------------------------
In late September 1990, the CFTC issued, by a 3 to 1 vote,
a formal ``statutory interpretation'' to make clear that 15-day
Brent transactions ``are excluded from regulation under the
[CEA] as sales of cash commodities for deferred shipment or
delivery.'' \60\ In determining that the 15-day contracts were
forward contracts, the CFTC stated ``it is significant that the
transactions create specific delivery obligations. Moreover,
the delivery obligations of these transactions create
substantial economic risk of a commercial nature to the parties
required to make or take delivery thereunder,'' such as theft,
damage, or deterioration of the crude oil to be delivered. The
CFTC majority noted that obligations for sale or delivery under
the 15-day contracts were not discharged through ``exchange-
style offset,'' but rather could be cancelled only through
individually negotiated agreements with the other parties in
the distribution chain. ``Under these circumstances,'' the
majority concluded, ``the Commission is of the view that
transactions of this type which are entered into between
commercial participants in connection with their business,
which create specific delivery obligations that impose
substantial economic risks of a commercial nature to these
participants, but which may involve, in certain circumstances,
string or chain deliveries of the type described above, are
within the scope of the [forward contract] exclusion from the
Commission's regulatory jurisdiction.'' \61\
---------------------------------------------------------------------------
\60\ 55 Fed. Reg. 39188 (Sept. 25, 1990). On June 29, 1990, the
CFTC had issued a draft statutory interpretation to the same effect.
The draft statutory interpretation was not published in the Federal
Register, the usual manner for public notice, but rather announced in a
CFTC advisory, CFTC Advisory No. 49-90, June 29, 1990, which was sent
only to several media outlets. The Advisory stated that a copy of the
draft interpretation was available from the Commission's Office of
Communication and Education Services, and that public comments were
invited until July 13, 1990. About a dozen comments were received.
\61\ Id.
---------------------------------------------------------------------------
Commissioner Fowler C. West dissented, questioning whether
the market had been so severely disrupted as to warrant such
extraordinarily quick action on a complex issue. He questioned
whether the majority's action, which he termed a significant
change from existing law, was more properly classified as a
rulemaking, which would require notice-and-comment, rather than
a statutory interpretation accompanied by a media advisory.
Commissioner West's dissent referenced the comments of the
Chicago Board of Trade (CBT), which noted that the current
methods for clearing and settlement in the 15-day Brent market
were the same as the antiquated clearing and settlement methods
previously used on the CBT more than 70 years ago, before the
CBT created a clearing corporation for all trades on the
exchange. ``The CBT stated that at the time Congress first
restricted futures trading to designated exchanges, CBT used a
`ring' method of clearing and settlement closely resembling
today's Brent market. CBT argues that `rather than
distinguishing 15-day Brent contracts from futures contracts,
the daisy chains, book-outs and cancellation agreements of
circles and loops confirm that the 15-day Brent market is
composed of the very kind of transactions intended to be
regulated as futures contracts.' '' \63\
---------------------------------------------------------------------------
\63\ West Dissent, at 10.
---------------------------------------------------------------------------
The dissent also noted that the 15-day contracts were
highly standardized, and that many of the companies urging the
CFTC not to regulate the 15-day Brent market as a futures
market had stated that these contracts were used for hedging
and price discovery, which is the primary purpose of the
futures markets.\64\ He also observed that traders in the 15-
day Brent market included speculators and traders who had no
intention of ever taking or making delivery. ``Those commenters
seem to want the Commission to exclude from regulation even
those hedging and pricing activities which Congress determined
the Commission should regulate under the Commodity Exchange
Act.'' \65\
---------------------------------------------------------------------------
\64\ See, e.g., Comment Letter of Phibro Energy, Inc., May 2, 1990
(``The participation by such entities in these markets provides price
protection for the participants both in the Brent and related physical
markets and adds significantly to the market's depth, liquidity,
pricing efficiency and pricing transparency.''); Comment Letter of
Mobil Oil Corp., May 2, 1990 (``Because of its relevance in the pricing
of a wide variety of international crude oils equity producers,
refiners and traders also enter into 15-day Brent contracts to manage
their price exposure in the market); Comment Letter of Bear Stearns,
April 30, 1990 (``The Brent crude oil market is used regularly by Bear
Stearns for its commercial needs, including as a hedging mechanism for
non-U.S. oil that, in Bear Stearns' view, cannot be as efficiently
protected under the New York Mercantile Exchange's futures contract
which is sensitive to domestic economic developments.''); see also
Comment Letter of Mobil Oil Corp. on Regulation of Hybrid and Related
Instruments, April 11, 1990 (``Mobil and other major participants in
these markets often enter into transactions to manage price risk,
rather than to transfer ownership of the underlying product.'').
\65\ West Dissent, at 12.
---------------------------------------------------------------------------
In conclusion, he wrote, ``Broadening the applicability of
the forward contract exclusion to include transactions by
traders who are speculators, who are not contemplating
delivery, who are using generally standardized contracts, who
routinely offset their positions and who do not use the
underlying commodity itself is an erroneous interpretation of
the Act.''
Although he disagreed with the majority's conclusion that
the 15-day Brent contracts were forward rather than futures
contracts, Commissioner West did not believe the 15-day
contracts needed to be traded on designated U.S. exchanges. He
suggested several alternatives for the treatment of the 15-day
Brent market that, in his opinion, would preserve the legal
validity of these contracts without changing the meaning of the
forward contract exclusion. His preferred alternative would be
for Congress to provide the CFTC with the authority to exempt
certain transactions from the exchange-trading requirement:
The cleanest way for the Commission to permit such
markets to operate without contract market designation
would be for it to have the authority to exempt certain
transactions by rule, regulation or order from the
exchange trading limitation of Section 4(a) of the Act,
when in the public interest to do so. The Brent
situation may demonstrate the desirability of such
authority. Congress could provide the Commission such
exemptive authority, and the Commission could then
exercise that authority in a manner recognizing
historic concerns about fraud and manipulation.\66\
---------------------------------------------------------------------------
\66\ West Dissent, at p.19. In an unusual move for a Federal
regulatory agency, the CFTC majority--Chairwoman Gramm and
Commissioners Kalo Hineman and William Albrecht--blocked the official
publication of Commissioner West's views. As a result of the majority's
action, in 1992, Congress amended the CEA to require the publication of
all dissenting opinions. ``Whenever the Commission issues for official
publication any opinion, release, rule, order, interpretation, or other
determination on a matter, the Commission shall provide that any
dissenting, concurring, or separate opinion by any Commissioner on the
matter be published in full along with the Commission opinion, release,
rule, order, interpretation, or determination.'' 7 U.S.C.A.
Sec. 4a(h)(3) (West 1999 & Supp 2002).
A couple of months later, ``still steamed'' about the
majority's handling of the Brent issue, Commissioner West again
took issue with the majority's actions.\67\ In a public speech,
Commissioner West expanded his criticisms of the procedures
used by the majority for its new interpretation of the forward
contract exclusion:
---------------------------------------------------------------------------
\67\ Securities Week, CFTC May Not Be Able to Live Down ``Mistake''
on Brent Oil Decision, December 3, 1990.
While the standard notice and public comment
procedures of rulemaking were not followed in issuing
the statutory interpretation, some dozen comments were
received. Even though the Commission issued a press
release inviting comments on the draft statutory
interpretation, this severely limited opening in the
decision-making process occurred only after some
individual commissioners became concerned about the
scope of the interpretation's coverage and insisted
that some public participation was necessary. Those
instincts were correct and should have been followed
farther.
At the very least the Commission, as an expert
agency, is obligated to take its own hard look at an
issue. This was not done. Instead, the majority of the
Commission seems to have relied on the representations
of parties with a substantial stake in the outcome of
our action. . . . The Commission has not made its own
independent study of [the Brent] market, nor has it
taken appropriate steps to seek out the views of those
parties who might oppose the proposition that Brent
transactions are forward contracts, as it likely would
have obtained in a rulemaking. These were the minimum
steps that we should have taken.\68\
---------------------------------------------------------------------------
\68\ Remarks by Commissioner Fowler C. West, CFTC, The Brent Issue:
More Than A Statutory Interpretation, before the Committee on
Commodities and Futures Law, New York State Bar Association, November
29, 1990.
Commissioner West again stated that the Brent contracts
were ``largely indistinguishable from futures contracts.''
Furthermore, he warned, ``The Commission may soon be paying a
price for its politically expedient statutory interpretation. I
doubt that its new forward contract exemption can be restricted
to large international oil and trading firms represented by
influential lawyers. The public, down the road, will suffer
from this fit of de-regulation, no matter how well-intended. I
believe Congress expects us to have more concern for the
public.'' \69\
---------------------------------------------------------------------------
\69\ Id.
---------------------------------------------------------------------------
Later, the North American Administrators Association
(NASAA), representing ``the 50 state securities agencies
responsible for investor protection and the efficient
functioning of the capital markets at the grassroots level,''
characterized the CFTC's response to the Transnor as ``quick,
but beyond its authority and misguided. In its attempt to calm
oil traders, producers, and purchasers, the CFTC went too
far.'' \70\ The state regulators viewed the CFTC's statutory
interpretation as incorrect and dangerous:
---------------------------------------------------------------------------
\70\ Hearing before the House Subcommittee on Environment, Credit,
and Rural Development, Committee on Agriculture, To Amend the Commodity
Exchange Act to Ensure the Continued Application of The Act's Antifraud
and Antimanipulation Protections, Statement of Wayne Klein, on behalf
of NASAA, June 30, 1993.
The CFTC's solution was a bad one. It decided to
``overrule'' the Transnor court and, in effect, create
an exemption. Since it lacked exemptive authority,
however, it chose to alter the traditional definitional
elements of a futures contract. The Commission
arbitrarily announced, under the guise of merely
``interpreting'' the law, that a new standard now
existed. As a result, the CFTC interpreted away its own
jurisdiction and disclaimed authority over a broad
category of products. The Commission seemed not to care
that by changing the definition of a futures contract,
the new criteria threatened to shield fraud in the
trading of other commodities--a hefty price to pay for
helping the oil companies.\71\
---------------------------------------------------------------------------
\71\ Id.
Shortly after he left the CFTC, Commissioner William
Albrecht described the reasoning underlying the CFTC's Brent
---------------------------------------------------------------------------
interpretation:
[Hybrids, swaps and Brent contracts] had some, but
not all, of the characteristics of a futures contract.
The law, however, did not contemplate the existence of
a partial futures contract--it was a futures contract
or it was not. In each case, however, the Commission
found a way to rule that it would not regulate these
instruments, even though they did contain futures or
options-like components. The Commission believed there
was not need to extend its regulatory system to these
instruments, either because they were regulated
elsewhere (hybrids) or the participants did not need
the type of regulation provided by the CFTC (swaps and
Brent oil contracts).\72\
---------------------------------------------------------------------------
\72\ William P. Albrecht, Regulation of Exchange-Traded and OTC
Derivatives: The Need for a Comparative Institution Approach, 21 Iowa
J. Corp. L. 111, 125 (1995).
Philip McBride Johnson, Chairman of the CFTC in the early
1980's, has since criticized the CFTC's Brent interpretation
for muddying the test for when an instrument is a futures
contract under the CEA: ``[T]he historical litmus test which
was coldly objective (no delivery? not a forward contract) has
been displaced by a devotion to form and process.'' \73\ The
former Chairman also described the relief in the financial
markets that followed the CFTC's 1989 swaps policy statement
and 1990 Brent statutory interpretation: ``With the CFTC's
withdrawal from regulating many of the more popular derivatives
in the late 1980's and early 1990's, it appeared that dealers
in those financial products had found a virtually regulation-
free promised land.'' \74\
---------------------------------------------------------------------------
\73\ Philip McBride Johnson, Derivatives, at 40 (1999).
\74\ Id.
---------------------------------------------------------------------------
C. Exemptions for Energy Contracts
1. Futures Trading Practices Act of 1992
Summary: Congress provided the CFTC with discretion to
exempt certain swaps and energy contracts that could be
considered to be futures contracts from CEA
requirements.
Although the CFTC quickly countered the Transnor decision
with its statutory interpretation relating to the Brent market,
the CFTC's actions did not eliminate the concern that another
court could declare certain derivatives, including swaps and
energy contracts, illegal under the CEA because they were not
traded on a designated futures exchange.\75\ Firms and traders
pressed Congress for a statutory amendment to the CEA to ensure
it would not be interpreted by courts in a manner that would
invalidate existing contracts and markets.
---------------------------------------------------------------------------
\75\ See, e.g., Securities Week, Legislation Needed to Resolve
Ambiguities Left by Transnor Settlement, May 28, 1990; Business Law
Brief, Brent Litigation Settled, June 1, 1990.
---------------------------------------------------------------------------
In 1992, Congress enacted the Futures Trading Practices Act
(FTPA) to amend the CEA to provide the CFTC with discretion to
determine that future contracts--or other instruments that
might be considered to be futures contracts--did not have to be
traded on a designated futures exchange. The Conference Report
accompanying the 1992 Act explains the rationale for the
exemptive authority:
[T]he conferees recognized the need to create legal
certainty for a number of existing categories of
instruments which trade today outside of the forum of a
designated contract market. These instruments may
contain some features similar to those of regulated
exchange-traded products but are sufficiently different
in their purpose, function, design, or other
characteristics that, as a matter of policy,
traditional futures regulation and the limitation of
trading to the floor of an exchange may be unnecessary
to protect the public interest and may create an
inappropriate burden on commerce.\76\
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\76\ H. Rept. No. 102-978, 102nd Cong., 2nd Sess. 81 (1992).
The FTPA established the principle that although a contract
may have some features of a futures contract, it does not
necessarily have to be traded on a designated exchange. It
provided the CFTC with the flexibility to determine the
appropriate level of regulation for novel types of financial
instruments, such as swaps and derivatives, that were becoming
popular in the market.\77\
---------------------------------------------------------------------------
\77\ Pub. L. 102-546, 106 Stat. 3590 (1992).
---------------------------------------------------------------------------
The report of the Senate Committee on Agriculture,
Nutrition, and Forestry accompanying the Senate bill explained
that in order to foster the development of new financial
instruments the CFTC needed to have the flexibility to
determine whether such new instruments that had some elements
of a futures contract need be traded on an approved exchange:
Since 1974, when Congress created the CFTC, the
principle of ``functional'' regulation was intended to
govern the introduction of new financial instruments:
``the CFTC would * * * regulate markets and instruments
that would serve a hedging and price discovery function
and the SEC would regulate markets and instruments with
an underlying investment purpose.'' S. Rept. 97-384,
97th Cong., 2nd Sess. 22 (1982).
But increasingly, this principle has become blurred
as novel ``hybrid'' instruments are developed. Bonds--a
traditional security--can be transformed to offer a
return indexed to the price of a commodity like oil or
gold. The final product may have significant attributes
of a commodity option or future.
This lack of clarity over the extent of CFTC
jurisdiction with respect to new ``hybrids'' and the
statutory requirement that all futures contracts must
trade on designated contract markets have combined to
create a legal cloud that may inhibit the emergence or
development of many such markets. Under current law,
the CFTC has the power to permit a commodity option to
trade off exchange in accordance with CFTC rules, but
the CFTC has no authority to exempt any futures product
from the exchange-trading requirement. This disparate
treatment could prevent the CFTC from permitting the
introduction of many economically useful new products
to the marketplace.\78\
---------------------------------------------------------------------------
\78\ S. Rept. 102-22, 102nd Cong., 1st Sess. 6 (1991).
Generally, the FTPA authorized the CFTC to exempt various
swap and hybrid transactions from the exchange-trading
requirements and other provisions of the CEA. Specifically, the
FTPA authorized the CFTC, either on its own initiative or upon
application of any person, to exempt from the exchange-trading
requirement, or any other requirement of the CEA, ``any
agreement, transaction, or class thereof--between ``appropriate
persons.'' \79\ The types of agreements that Congress intended
the CFTC to initially exempt under this authority included a
variety of OTC derivatives, such as non-standardized swap
agreements, ``hybrid instruments that are predominantly
securities or depository instruments,'' forward contracts, and
bank deposits and accounts. The ``appropriate persons'' who
could be authorized to trade in these instruments off-exchange
included large commercial institutions, such as banks, savings
associations, insurance companies, investment companies,
commodity pools, large corporations, employee benefit plans,
governmental entities, securities brokers, and futures
merchants and brokers.
---------------------------------------------------------------------------
\79\ Section 4(c)(1) of the CEA, as amended by the FTPA, provides
the CFTC with authority to exempt from the CEA, ``any agreement,
contract, or transaction (or class thereof) that is otherwise subject
to subsection (a) . . .'' (emphasis added). The contracts that are
``otherwise subject to subsection (a)'' are futures contracts ``for the
purchase or sale of a commodity for future delivery,'' which, under the
CEA, ``does not include any sale of any cash commodity for deferred
shipment or delivery,'' i.e., a forward contract. 7 U.S.C.A.
Sec. Sec. 1a(11), 6(a), (c) (West 1999 & Supp. 2000).
---------------------------------------------------------------------------
Congress qualified this broad exemptive authority in
several respects. First, the Conference Report emphasized that
the exemptive authority should be applied narrowly to the four
specified categories of instruments--swaps, hybrids, forward
contracts, and bank deposits and accounts. The conferees stated
that any further exemptions should be granted only after
further study and deliberation by Congress:
The goal of providing the Commission with broad
exemptive powers is not to prompt a wide-scale
deregulation of markets falling within the ambit of the
Act. Rather, it is to give the Commission a means of
providing certainty and stability to existing and
emerging markets so that financial innovation and
market development can proceed in an effective and
competitive manner. Except as discussed below, the
Conferees do not intend for the Commission to use this
authority to grant broad exemptions from the Act for
instruments or markets before these studies are
completed and Congress has ultimately decided the
issues raised by them.\80\
---------------------------------------------------------------------------
\80\ H. Rept. No. 102-978, at 81.
The conferees specifically directed the CFTC to consider
whether to grant the 15-day Brent market an exemption under
---------------------------------------------------------------------------
this new authority:
One court has found transactions in the Brent crude
oil market to be futures contracts. See Transnor
(Bermuda) Limited v. BP North America Petroleum, 738
F.Supp. 1472 (1990). In response, the Commission has
issued a statutory interpretation to the effect that
certain transactions in that market qualify as sales of
cash commodities for deferred shipment or delivery,
that is, forward contracts, and, as such, are not
subject to regulation under the Act.
Many markets of this nature are international in
scope; foreign parties are already engaging in such
transactions free of restraints imposed by the Act that
may create competitive disadvantages for U.S.
participants.
Without expressing a view regarding the applicability
of the Commission's statutory interpretation, the
Conferees encourage the Commission to review this
situation and these contracts to determine whether
exemptive or other actions should be taken.\81\
---------------------------------------------------------------------------
\81\ Id. at 82.
Second, in determining whether to grant any exemption,
Congress intended that the CFTC nonetheless be able to
effectively regulate the affected markets within its
jurisdiction. Before granting any exemption, the CFTC was
required to find that such exemption would be ``consistent with
the public interest'' and the purposes of the Act, and ``will
not have a material adverse affect on the ability of the
Commission or any contract market to discharge its regulatory
or self-regulatory duties under this Act.''
The Conference Report emphasized that in granting exemptive
authority for certain instruments it was not making any
determination that such instruments were futures within the
scope of the Act, and that in making any determination to
exempt instruments from the exchange-trading requirement the
CFTC need not make any such determination. ``Rather, this
provision provides flexibility for the Commission to provide
legal certainty to novel instruments where the determination as
to jurisdiction is not straightforward.'' \82\
---------------------------------------------------------------------------
\82\ Id.
---------------------------------------------------------------------------
Passage of the FTPA reduced the importance of categorizing
financial instruments as futures or forward contracts. Under
the FTPA, even if an instrument is classified as a futures
contract within the jurisdiction of the CFTC, as opposed to a
forward contract outside of the scope of the CEA, the CFTC may
determine that the exchange-trading requirement or other
requirements of the CEA do not apply.
2. CFTC Exemption for Energy Contracts
Summary: The CFTC exempted energy contracts between
large companies from the exchange-trading requirement
and the anti-fraud provisions of the CEA.
a. CFTC Order Granting Exemption
The Futures Trading Practices Act was signed into law on
October 28, 1992. Two and a half weeks later, on November 16,
nine crude oil, natural gas, and other energy businesses filed
with the CFTC an application for an exemption under the new Act
from the exchange-trading requirement for certain transactions
in energy contracts.\83\
---------------------------------------------------------------------------
\83\ The nine firms were BP Oil Company, Coastal Corporation,
Conoco Inc., Enron Gas Services Corp., J. Aron & Company, Koch
Industries, Inc., Mobil Sales and Supply Corp., Phibro Energy Division
of Solomon Inc., and Phillips Petroleum Company. Hearing before the
House Subcommittee on Environment, Credit, and Rural Development,
Committee on Agriculture, To Amend the Commodity Exchange Act to Ensure
the Continued Application of the Act's Antifraud and Antimanipulation
Protections, June 30, 1993, at 132.
---------------------------------------------------------------------------
On January 21, 1993, on the final day of the Administration
of President George H.W. Bush, the CFTC approved a final rule
exempting certain non-standardized swap agreements from the
requirement that all futures contracts be traded on a
designated exchange.\84\ At the same time, it issued a proposed
order granting a similar exemption to large commercial
participants in various energy contracts.\85\
---------------------------------------------------------------------------
\84\ 55 Fed. Reg. 5587 (1993). The CFTC's rule adopted the same
definition of ``swap agreement'' that is used in the Bankruptcy Code,
11 U.S.C. 101 (55), and limited the exemption's applicability to a
subset of ``appropriate persons'' that were termed by the rule as
``eligible swap participants.'' The swap agreements that were eligible
for the exemption could not be ``part of a fungible class of agreements
that are standardized as to their material economic terms.''
\85\ 58 Fed. Reg. 6250 (1993).
---------------------------------------------------------------------------
On April 20, 1993, the CFTC approved, by a 2 to 1 vote, a
final order granting an exemption for energy contracts from the
exchange-trading requirement of the CEA, ``thereby formalizing
with an express order a previous interpretative order which
stemmed from the Brent Oil-Transnor dispute.'' \86\ The CFTC's
final order applied only to contracts among a limited class of
large commercial participants who were ``appropriate persons''
under the FTPA, such as a bank, trust company, large
corporation, securities broker-dealer, or a futures commission
merchant. To qualify for the exemption, these commercial
participants must, in connection with their business activities
incur risks, in addition to price risks, related to the
underlying physical commodities, such as the risks of damage in
transit, and the participants in the transaction also must be
able to make or take delivery of the commodity.
---------------------------------------------------------------------------
\86\ Securities Week, CFTC Has Split Vote Over Regulatory Exemption
for Forward Energy Contracts, April 19, 1993; 58 Fed. Reg. 21286
(1993).
---------------------------------------------------------------------------
The final order was not limited to Brent contracts, but
applied to a broad class of energy contracts ``for the purchase
and sale of crude oil, condensates, natural gas, natural gas
liquids or their derivatives which are used primarily as an
energy source.'' To qualify for the exemption, such contracts
must be: (1) between covered commercial participants; (2)
individually negotiated; and (3) impose binding obligations to
make and receive delivery of the underlying commodity. With
respect to the latter condition, the CFTC's order stated that
there must be ``no right of either party to effect a cash
settlement of their obligations without the consent of the
other party . . . provided, however, that the parties may enter
into a subsequent book out, book transfer, or other such
contract which provides for the settlement of the obligation in
a manner other than by physical delivery of the commodity
specified in the contract.'' \87\
---------------------------------------------------------------------------
\87\ In a reference to the daisy-chain method of settling 15-day
Brent contracts, the CFTC explicitly clarified that the obligation to
take delivery could be satisfied ``regardless of whether the buyer
lifts or otherwise takes delivery of the cargo or receives pipeline
delivery, or as part of a subsequent contract, passes title to another
intermediate purchaser in a `chain,' `string' or `circle' within a
`chain.' ''
---------------------------------------------------------------------------
Although the final order exempted these energy contracts
from the exchange-trading requirement, the CFTC stated it would
continue to apply the basic statutory authorities under
sections 6(c), 6c, 6(d), and 9(a)(2) of the CEA to prevent
manipulation.\88\ The CFTC stated that these anti-manipulation
provisions will continue to apply, ``to the extent that these
provisions prohibit manipulation of the market price of any
commodity in interstate commerce or for future delivery on or
subject to the rules of any contract market. . . .''
---------------------------------------------------------------------------
\88\ Section 6(c) provides the CFTC with authority to issue a show
cause order and conduct a subsequent administrative hearing to prohibit
any person from trading if there is reason to believe the person has
manipulated, attempted to manipulate, or is manipulating or attempting
to manipulate the market price of any commodity. 7 U.S.C.A.
Sec. Sec. 9, 15 (West 1999 & Supp. 2002).
Section 6c authorizes the CFTC to bring an action in Federal
court to obtain a temporary or permanent injunction or restraining
order whenever it appears that any person has violated or is about to
violate any provision of the CEA or CFTC rule. 7 U.S.C.A. Sec. 13a-1
(West Supp. 2002).
Section 6(d) authorizes the CFTC to issue cease and desist orders
in manipulation cases, and levy civil penalties for failure to obey
such orders. Id. at Sec. 13b.
Section 9(a)(2) makes manipulation of or attempts to manipulate
the price of a commodity a felony punishable by a fine of up to
$1,000,000 and imprisonment of up to 5 years. Id. at Sec. 13.
---------------------------------------------------------------------------
In the most controversial aspect of its decision, the CFTC
stated that the anti-fraud provisions of the CEA would not
continue to apply to energy contracts. The CFTC majority stated
that most comments agreed with the views expressed by one
commenter, that `` `given the commercial characteristics of
these transactions and the significant requirements to be
`commercial participants' and `appropriate persons,' the
[commenter] * * * does not believe that section 4[4b] of the
Act (anti-fraud) should be applied to Energy Contracts.' '' The
majority stated, ``In this particular instance, the Commission
concurs with the commenters that it need not retain section 4b
authority, to whatever extent that section of the Act would
otherwise be applicable to these transactions.''
In his concurring opinion, Acting Chairman William Albrecht
explained the CFTC ``has never regulated this market, nor has
sought to regulate it.'' Further, he stated, ``The Commission
is not aware of fraudulent practices perpetrated against the
general public by the participants in this market, nor indeed
have any of the commercial participants in this market
complained to the Commission of any fraudulent practices by
other participants.'' Because this market ``is characterized by
principal to principal transactions between large sophisticated
commercial entities,'' the Acting Chairman wrote, ``there
generally do not appear to be any concerns about the ability of
these market participants to perform their obligations.''
Acting Chairman Albrecht wrote, ``There does not appear to be
any reason sufficient to justify commission regulation, nor any
necessity for the Commission to involve itself in this
market.''
Just before the CFTC's final vote granting this exemption,
the Acting Chairman emphasized his view that the CFTC had no
knowledge of the energy markets and therefore had no ability to
monitor those markets. ``In fact,'' Albrect stated, ``the CFTC
does not and cannot supervise this market.'' \89\
---------------------------------------------------------------------------
\89\ Alan Kovski, CFTC Exempts Cash Market from Controls, The Oil
Daily, April 14, 1993.
---------------------------------------------------------------------------
Commissioner Sheila Bair dissented from the majority's
``failure to retain the general anti-fraud provisions contained
in section 4b and 4o of the Commodity Exchange Act.'' She
criticized the majority's reasoning in several ways. First, she
wrote, the Commission ``has never recognized an exemption to
its jurisdiction based solely on the `commerciality' of the
participants, nor can I see any policy reason why commercial
firms engaging in futures transactions should not have the
basic protection of our anti-fraud provisions.''
Commissioner Bair also disagreed with the majority's
position that sophisticated market participants do not need the
anti-fraud protections of the CFTC, arguing that ``if we are to
rationalize exemptions from anti-fraud and other components of
our regulatory scheme on the basis of `sophistication' of
market users, we might as well close our doors tomorrow,
because approximately 98 percent of users of regulated,
exchange-traded futures'' would meet the eligibility
requirements of the exemption.
Commissioner Bair stated that the exemption from the anti-
fraud provisions went far beyond what was necessary in the case
at hand and set a ``dangerous precedent'':
What is especially frustrating to me is that we do
not need to paint ourselves into this corner. The main
reason why the CFTC sought general exemptive authority
in last year's reauthorization was so that we would
have the flexibility to craft appropriately tailored
exemptive relief based on public policy considerations,
instead of having to deal with the ``all or nothing''
jurisdictional decisions we had to make in the past.
Yet, we are still following this ``all or nothing''
approach, when in my view, we should be carefully
weighing individual aspects of our regulatory structure
and making a reasoned determination as to which
requirements should and should not apply to a
particular class of transactions. And, for the reasons
I have stated, I do not believe the case has been made
for providing an exemption from basic anti-fraud
provisions.
A Washington Post article also sounded this cautionary note
as to the potential effect of this exemption for energy
contracts:
The CFTC's decision not to regulate energy contracts
means the Federal Government will have no way of
monitoring these growing markets in which huge sums of
dollars change hands every year. If a big player failed
to make good on a contract, the other participant might
suffer such huge losses that it, too, would default on
contracts, sending the ripples throughout the financial
system.\90\
---------------------------------------------------------------------------
\90\ Jerry Knight, Energy Firm Finds Ally, Director in CFTC Ex-
Chief, The Washington Post, April 17, 1993.
At the time of this CFTC decision in 1993, the collapse of
Enron and the evidence of fraud and manipulation in energy
markets in the late 1990's were still several years in the
future.
b. Congressional Hearings on CFTC Order
Barely a week after the CFTC granted the exemptions for
energy contracts, Representative Glenn English, Chairman of the
House Agriculture Subcommittee with jurisdiction over the CFTC,
held a hearing on the CFTC's decision to exempt these contracts
from the CEA's anti-fraud provisions.\91\
---------------------------------------------------------------------------
\91\ John M. Doyle, House Chairman Slams CFTC Exemption of Off
Exchange Energy Contracts, The Associated Press, April 28, 1993.
---------------------------------------------------------------------------
Acting Chairman Albrecht defended the Commission's
position, contending that retention of anti-fraud authority
over the energy markets would actually be worse for the public
than granting the exemption. Retention of this authority, in
his view, ``would inject the illusion of Commission supervision
into a market where there is none. In that regard, some may
take comfort from the coverage of 4b [anti-fraud authority],
but it would be cold comfort indeed without the benefits of any
ongoing regulation. After all, the Commission just does not
have the resources necessary to adequately regulate these
markets. In short, the benefits of extending the coverage of 4b
to this market are not apparent.'' \92\
---------------------------------------------------------------------------
\92\ Statement of Dr. William P. Albrecht, Acting Chairman, CFTC,
Hearing before the House Subcommittee on Environment, Credit, and Rural
Development, Committee on Agriculture, Review of the Commodity Futures
Trading Commission's Discretion to Exempt Certain Transactions from
Antifraud Provisions of the Commodity Exchange Act (hereinafter House
April 1993 Hearing), April 28, 1993, at 53.
Dr. Albrecht also voiced the concern that regulation would drive
markets overseas: ``I am concerned that maintaining section 4b
authority over this market would provide little, if any, benefit, and
perhaps cause very real harm. If section 4b remains an issue, some
international commercial participants will continue to refuse to do
business with U.S. energy firms, and some U.S. firms will set up off-
shore branches. In short, retaining 4b authority will damage U.S.
international competitiveness.'' Id.
---------------------------------------------------------------------------
Acting Chairman Albrecht made it clear that, in his view,
the CFTC should maintain minimal regulatory authority over the
energy markets:
The genius of [the FTPA] authority is that it frees
us from the increasingly meaningless debate over
whether something is a future or not. Instead, we can
concentrate on designing the appropriate regulatory
scheme for products that have futures-like
characteristics.
We can consider how much regulation by the CFTC is
needed based upon the characteristics of the market,
such as the customer base, the market's purpose, the
potential for fraud, and the availability of other
governmental oversight.
For some products, such as the energy contracts under
discussion today, this may mean almost no oversight by
the CFTC. For others, such as swaps, we've decided to
maintain more oversight.\93\
---------------------------------------------------------------------------
\93\ House April 1993 Hearing, supra at 11.
Albrect noted that the participants in the energy markets
``are large commercial entities, well aware of their
contractual rights and legal remedies,'' so that they neither
needed nor wanted the protections afforded by the statute.
``This market has been in operation for over a century, and has
gotten along just fine without CFTC oversight,'' he
testified.\94\
---------------------------------------------------------------------------
\94\ Id.
---------------------------------------------------------------------------
Commissioner Bair, who dissented from the CFTC's decision,
told the House Subcommittee, ``To my knowledge, it is
unprecedented for the Commission to provide relief from
antifraud protections for transactions that are not subject to
the jurisdiction of another regulator.'' \95\
---------------------------------------------------------------------------
\95\ Prior to the decision, several senior CFTC officials had
raised concerns with the proposed exemption from the anti-fraud
requirements. The CFTC's Director of Enforcement commented there was no
precedent in the securities laws for an exception to the anti-fraud
protections, stating that ``we are not aware of any Securities and
Exchange Commission exemption that excludes securities products from
anti-fraud jurisdiction.'' Memorandum from Dennis Klejna, Director,
Division of Enforcement, to Gerry Gay, Director, Division of Economic
Analysis, April 8, 1993, reprinted in Hearing before the House
Subcommittee on Environment, Credit, and Rural Development, Committee
on Agriculture, Amend the Commodity Exchange Act to Ensure the
Continued Application of The Act's Antifraud and Antimanipulation
Protections (hereinafter House June 1993 Hearing), June 30, 1993, at 6-
7.
Similarly, the Director of the Division of Trading and Markets
wrote, ``To my knowledge, the Commission has never before exempted
transactions in products subject to its jurisdiction from the anti-
fraud provisions of the Act unless another regulatory regime clearly
applied to such transactions.'' Memo from Andrea M. Corcoran, Division
of Trading and Markets, to Files, Exemption for Certain Contracts in
Energy Products, April 9, 1993, reprinted in House April 1993 Hearing,
supra at 85-87.
---------------------------------------------------------------------------
NASAA, an organization representing the securities agencies
of the 50 states, voiced its concerns regarding ``a more
general (and disturbing) trend at the CFTC--that is,
increasingly inadequate and lax oversight of the commodities
markets.'' \96\ NASAA described the energy contract exemption
as:
---------------------------------------------------------------------------
\96\ Testimony of Wayne Klein, NASAA, House June 1993 Hearing, at
144, 147.
Just the latest example of what perhaps may be best
characterized as the agency's ``reluctance to
regulate,'' even in the face of blatant threats to
investors and the integrity of the markets. Worse yet,
the Commission has vigorously guarded what it believes
to be its ``turf,'' only to turn around and severely
limit its own regulatory role. This minimalist approach
seems to be one of ``we won't police the area but we
don't want anyone else to either.''
* * *
I am deeply concerned that during the past several
years, the CFTC has embarked on a course of abandoning
and repudiating its responsibilities to protect the
integrity of the categories of energy products from the
anti-fraud and anti-manipulation provisions of the CEA
is the most recent, and a most egregious, example of
this new course. Without active and vigorous oversight,
the markets under the CFTC's exclusive jurisdiction
invite fraud and abusive trading.\97\
---------------------------------------------------------------------------
\97\ Id.
Chairman English took issue with the rationale that large
sophisticated players in the market did not need the CEA's
---------------------------------------------------------------------------
protections against fraud:
I've heard, ``Well, these are big boys. Let them take
care of themselves.'' I would suggest to you, before
this thing is done, as a consequence of your actions,
there are going to be some little people that are going
to get hurt, too. They may be big in our part of the
country, but they're little in this world, and it seems
like, that any time when the big people get hurt, they
have to fall someplace, and they fall on an awful lot
of little people. The little folks end up bearing a
good deal of this burden.\98\
---------------------------------------------------------------------------
\98\ House April 1993 Hearing, supra at 22.
Near the end of the hearing, Chairman English expressed
---------------------------------------------------------------------------
frustration with the CFTC's position:
It brings us down to the real question of ``What in
God's name is the CFTC all about?'' If it's not--if we
can't even count on the CFTC to protect the public from
fraud, if we can't depend on the CFTC not to give away
the store, from the standpoint of giving blanket--not
exemptions, exclusions--that's an outrage. . . . [w]hen
it comes down to opening the door to fraud, that's
simply going too far. That's not deregulation, that's
just blatant irresponsibility. . . . In the 18 years
I've been in Congress, this is the most irresponsible
decision I've come across.\99\
---------------------------------------------------------------------------
\99\ Id., at 44-45. At this hearing Chairman English revealed that
during the rulemaking process on the exemption for swap agreements the
CFTC had intended to exempt those swap agreements from the anti-fraud
provisions as well. Chairman English recounted that when this decision
``was barreling down the track about 90 miles an hour,'' he telephoned
Chairwoman Gramm to express his ``grave concerns'' about this aspect of
the decision. Id. at 23. The CFTC decided not to include the removal of
anti-fraud authority in the final swap agreement exemption.
Immediately after the hearing, Chairman English ``told
reporters the acting head of the agency `would do a real
service to the country' if he resigned.'' \100\
---------------------------------------------------------------------------
\100\ John M. Doyle, House Chairman Slams CFTC Exemption of Off
Exchange Energy Contracts, The Associated Press, April 28, 1993.
---------------------------------------------------------------------------
Two months later, Chairman English held another hearing,
this time focusing on legislation he had introduced to overturn
the CFTC's energy contract order insofar as it exempted such
contracts from the CEA's anti-fraud provisions. His bill also
would have prohibited the CFTC from granting any exemptions
under the FTPA to the anti-fraud and anti-manipulation
provisions of the CEA.
In testimony opposing the legislation, the CFTC majority
reiterated the rationale it had previously stated in its order
and at the prior hearing. But the CFTC went even further,
extending its exemptive reasoning to the CEA's anti-
manipulation provisions as well. Writing for himself and
Commissioner Dial, Acting Chairman Albrecht stated there was no
need to retain anti-manipulation authority over the energy
markets:
The concerns raised about eliminating Commission
flexibility with regard to anti-fraud jurisdiction also
apply to manipulation jurisdiction. There does not
appear to be a need for retaining this authority, there
will not be significant benefits gained by retaining it
generally and there are very real burdens to be placed
on the exempt markets.\101\
---------------------------------------------------------------------------
\101\ House June 1993 Hearing, supra at 101.
During this hearing, the CFTC made it clear that it
intended to apply the 1990 Brent Statutory Interpretation to
the Brent market, and therefore exclude the 15-day Brent
contracts from all regulation under the CEA, rather than
consider them merely exempt energy contracts under the new 1993
energy contracts exemption. This distinction between excluded
forwards contracts, which are not subject to the CEA at all,
and exempt derivatives contracts, which are subject to a
limited form of regulation, first appeared following the CFTC's
creation of the 1993 energy contract exemption. This
distinction has become increasingly significant following
enactment of the Commodity Futures Modernization Act of 2000,
which bases a number of provisions upon this distinction.
Commissioner Bair, who opposed the CFTC's broad energy
contract exemption, still supported the Brent exclusion. In her
testimony in support of Chairman English's bill, she wrote that
the bill ``will achieve the important goal of ensuring that the
anti-fraud and anti-manipulation protections of the Act
continue to apply to transactions exempted by the Commission
from other regulatory requirements. Preserving such authority
in no way implies that particular types of exempted off-
exchange transactions such as traditional swaps or 15-day Brent
Oil contracts are in fact future contracts subject to CFTC
jurisdiction.'' \102\
---------------------------------------------------------------------------
\102\ Id. at 104-5.
---------------------------------------------------------------------------
Kenneth Raisler, an attorney representing the Energy
Group--the nine companies that had applied for the energy
contracts exemption--testified that although the Energy Group
was ``adamantly opposed to fraud in any market,'' repealing the
exemption from the anti-fraud provision would not be effective.
According to these companies, the CFTC did not have the ability
to regulate energy markets. ``In our view, application of the
CFTC's antifraud jurisdiction only confuses the picture. The
CFTC has never overseen or been involved in policing these
markets. I believe that is just a critically important point.
Without the staff or the expertise, retaining antifraud
jurisdiction could create a misleading impression about the
CFTC's abilities.'' \103\
---------------------------------------------------------------------------
\103\ House June 1993 Hearing, supra at 121. In an exchange with
Rep. Jim Nussle (R-Iowa), Mr. Raisler confirmed that the Energy Group
wanted no regulation at all of energy contracts under the Federal
commodity laws, regardless of the CFTC's abilities:
Mr. NUSSLE: OK, but the bottom line though is that the real
remedy that you are prescribing in the alternative of this legislation
is the civil courts. You are basically saying let the buyers beware,
let the market beware, and you are on your own, you take care of it on
your own. You have to investigate it, you have to uncover it, you have
to be aware of it, and then you have to prosecute it.
Mr. RAISLER: And let me point out, as a general matter in this
country the buying and selling of goods, whether they be energy or any
other kind of product, find themselves with that remedy, yes.
* * *
Mr. NUSSLE: And the Government has no place regulating or
monitoring that particular transaction, in your opinion?
Mr. RAISLER: The Government never has, and so we see no reason
for them to start now.
Id. at 131.
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The Chairman of the Chicago Board of Trade, Patrick Arbor,
testified as to the higher burden of proof the various CFTC
exemptions imposed for claims of fraud and manipulation in the
energy markets:
Under the swaps exemption, anyone manipulating the
price of an exempt swap would not violate the CEA
unless that manipulation effected a ripple manipulation
on a futures exchange or in the cash market as a whole.
The swaps exemption also may be illusory or at least
cumbersome when it comes to fraud. Any fraud action
would require the complaining party to prove first that
the swap is a futures contract and second that fraud
occurred. Other than shielding wrongdoing, no reason
exists to make the complaining party make a double
showing. The energy contract exemption has the same
flaw in the manipulation area as the swaps exemption
and contains no antifraud provision.\104\
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\104\ Statement of Patrick H. Arbor, Chairman, CBOT, Hearing To
Amend the Commodity Exchange Act to Ensure the Continued Application of
the Act's Antifraud and Antimanipulation Protections, June 30, 1993, at
134-5 (emphasis added).
Chairman English's bill was reported out of his
subcommittee, but made it no further in the legislative
process.
D. The Commodity Futures Modernization Act of 2000
1. Regulatory Uncertainty Following the FTPA
Although the Congress attempted to clarify the legal status
of certain derivative and swap instruments with the passage of
the FTPA in 1992, subsequent events led to continued
uncertainty and renewed calls for Congressional clarification.
Most of these issues concerned the regulation of financial
swaps and derivatives. Calls for Congressional action
intensified after a 1995 CFTC enforcement proceeding alleging
market manipulation by MG Refining and Marketing, Inc. and MG
Futures, Inc., in which the CFTC again sought to define ``all
the essential elements of a futures contract.'' Although the
CFTC indicated it did not intend to change the meaning of a
futures contract under the CEA, and did not seek to impose new
regulations upon the swaps and derivatives industry, the CFTC's
action nonetheless raised anew the concerns that these
instruments could someday be declared unenforceable as illegal
futures contracts.\105\
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\105\ See, e.g., Statement Submitted on Behalf of The International
Swaps and Derivatives Association, Inc., to the Senate Committee on
Agriculture, Nutrition, and Forestry, 105th Cong., 2nd Sess., July 28,
1998. (``The possibility that some or a substantial category of
privately negotiated derivatives transactions may be interpreted, even
inadvertently, to be futures contracts also raises serious concerns
with respect to those transactions falling outside the scope of the
current or a future revised Swaps Exemption, particularly equity swaps
and other swaps based on the prices of securities.'').
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A ``concept release,'' issued by the CFTC in May 1998, to
``reexamin[e] its approach to the over-the counter derivatives
market'' also caused alarm in the financial community.\106\
Although the CFTC stated that the release ``in no way alters
the current status of any instrument or transaction'' under the
CEA, the industry viewed it as the beginning of an attempt to
increase the CFTC's role in regulating aspects of the OTC
derivatives markets. ``Until the Concept Release,'' the Swap
Dealers told Congress, ``the CFTC appeared to have worked on
the assumption that a contract is subject to their jurisdiction
if they determine it to be a futures contract, and is not
subject to the Act until then. But under the Concept Release,
the CFTC moved to the other side and asserted that all
derivatives are automatically subject to its jurisdiction,
unless it affirmatively states otherwise.'' \107\ In response
to objections of the financial industry, in the Agriculture
Appropriations Act for fiscal year 1999, Congress imposed a 6-
month moratorium on the CFTC's rulemaking authority in this
area.
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\106\ Id.
\107\ Id.
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The rapid development of computerized trading systems for
OTC derivatives complicated the regulatory picture as well. The
CFTC's existing swap exemption only applied to swaps that were
not entered into on an exchange. The question arose as to
whether computerized OTC trading systems that automatically
facilitated negotiations between multiple parties were more
akin to the trading floor of an exchange or more like
electronic communication systems, such as telephones and fax
machines. To many, analysis based on such distinctions elevated
form over substance. ``Market participants . . . have argued
that the means to execute a swap agreement (computer systems
rather than telephonic systems) should not alter the regulatory
status of the agreement.'' \108\
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\108\ U.S. Department of the Treasury, the Board of Governors of
the Federal Reserve System, Securities Exchange Commission, and
Commodity Futures Trading Commission, Report of The President's Working
Group on Financial Markets, Over-the-Counter Derivatives Markets and
the Commodity Exchange Act (November 1999), at 14.
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This and other regulatory issues were addressed in the
Report of The President's Working Group on Financial Markets,
Over-the-Counter Derivatives Markets and the Commodity Exchange
Act, which was prepared jointly by the Department of the
Treasury, the Board of Governors of the Federal Reserve System,
the SEC, and the CFTC, and issued in November 1999. ``A cloud
of legal uncertainty has hung over the OTC derivatives markets
in the United States in recent years,'' the Report stated,
``which, if not addressed, could discourage innovation and
growth of these important markets and damage U.S. leadership in
these arenas by driving transactions off-shore.''
The President's Working Group issued a number of
recommendations for the treatment of financial instruments,
including a CEA exclusion for bilateral swap agreements between
certain participants (termed ``eligible swap
participants''),\109\ and a CEA exclusion for certain types of
electronic trading systems involving those same participants.
The Working Group was clear, however, that any exclusions from
the CEA should be limited to ``markets that are not readily
susceptible to manipulation and that do not currently serve a
significant price discovery function.'' To this extent, the
Report stated that the recommended exclusions ``should not
extend to any swap agreement that involves a non-financial
commodity with a finite supply.'' The Working Group explained:
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\109\ The ``eligible swap participants'' who could qualify for this
exclusion would be regulated financial institutions, large
corporations, certain pension funds, state and local governments, and
individuals with significant assets.
Due to the characteristics of markets for non-
financial commodities with finite supplies, however,
the Working Group is unanimously recommending that the
exclusion not be extended to agreements involving such
commodities. For example, in the case of agricultural
commodities, production is seasonal and volatile, and
the underlying commodity is perishable, factors that
make the markets for these products susceptible to
supply and pricing distortions and to manipulation.
There have also been several well-known efforts to
manipulate the prices of certain metals by attempting
to corner the cash or futures markets. Moreover, the
cash market for many non-financial commodities is
dependent on the futures market for price discovery.
The CFTC should, however, retain its current authority
to grant exemptions for derivatives involving non-
financial commodities, as it did in 1993 for energy
products, where exemptions are in the public interest
and otherwise consistent with the CEA.\110\
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\110\ Id. at 16-17. In footnotes, the Working Group added that
``nothing in this report should be construed to affect the scope of
exemptions that are currently in effect,'' and recommended the CFTC
``retain its current exemptive authority for these [non-financial
commodity] derivatives.''
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2. Enactment of Commodity Futures Modernization Act
a. Summary of Relevant Provisions
In 2000, Congress enacted the Commodity Futures
Modernization Act (CFMA). The CFMA overhauled the regulatory
framework for financial and energy derivatives under the CEA.
Consistent with the recommendations of the President's Working
Group, the CFMA sought to clarify the exclusion of various
financial derivatives from the scope of the CEA, and to
establish a tiered regulatory system for the commodities and
derivatives within the scope of the CEA, with the degree of
regulation dependent upon the type of product (such as
financial, agricultural, energy or metals), the type of market
(such as designated exchanges, bilateral negotiation,
multilateral negotiation, or electronic exchange), and the type
of participant in the marketplace (such as retail customer,
sophisticated player, or speculator). Generally, the CFMA
subjects markets that restrict trading to professional traders
or commercial participants and trade in products that are less
susceptible to manipulation to less regulation than markets
with a broader range of participants or with commodities in
finite supply.
The CFMA resolved the longstanding concern regarding the
legal enforceability of OTC derivatives that were not traded on
an approved exchange. The CEA now provides that no swap
agreement between eligible contract participants shall be
unenforceable under the CEA or any other law based on a failure
to comply with any exclusion or exemption from any provision of
the CEA.\111\
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\111\ 7 U.S.C.A. Sec. 25 (West Supp. 2002).
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A significant number of provisions in the CFMA address
issues related to the regulatory treatment of a variety of
financial instruments. Most of these complex provisions are not
directly relevant to the issue of the regulation of energy
contracts under the CEA. Accordingly, this report examines the
provisions of the CFMA only insofar as they relate to or are
entangled with issues regarding the regulation of energy
contracts, such as those involving crude oil. Table A.2-2
provides a summary of the regulation of energy derivatives
under the CFMA. Table A.2-3 identifies the key dates in the
regulation of the commodity markets up to and including the
enactment of the CFMA.
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(i) Categories of Participants
One of the criteria used by the CFMA for determining the
level of regulation under the CEA is the nature of person
involved in the transaction. Generally, the Act only provides
exclusions and exemptions for transactions between large
institutions or individuals with large personal assets, who are
either (1) deemed to be sufficiently sophisticated to be able
to protect their own interest, or (2) subject to another
regulatory scheme, such as the banking or securities laws. For
transactions and markets in which the general public or small
businesses participate, the full regulatory apparatus of the
CEA still applies.
Most of the exclusions and exemptions provided by the CFMA
apply to those large organizations that qualify as an
``eligible contract participant'' (``ECP''), the definition of
which includes financial institutions; insurance companies;
corporations, trusts, and partnerships with total assets
greater than $10 million; large pension benefit plans,
governmental entities, natural persons with assets greater than
$5 million who are entering the transaction for risk management
purposes, and certain others.\112\
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\112\ The CFMA's definition of ECP is based upon the CFTC's
definition of ``eligible swap participant'' used for the 1993 swap
exemption, but is slightly broader. See 17 CFR Part 35.
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A subset of ``eligible contract participants'' qualify for
further exemptions and exclusions. An ``eligible commercial
entity'' is an eligible contract participant that (i) has the
ability to make or take delivery of the commodity; (ii) incurs
commodity risks in addition to price risks; or (iii) is a
dealer in either the commodity or derivatives transactions
involving that commodity.\113\ In essence, this category
applies to large traders that make or take delivery of a
physical commodity, such as, for example, energy trading
companies like Enron, Williams Company, Duke Energy, and El
Paso Corporation.
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\113\ 7 U.S.C.A. Sec. 1a(11) (West Supp. 2002).
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(ii) Categories of Commodities.
The CFMA also created three categories of commodities.
``Excluded commodities'' are a variety of financial
derivatives, including interest rate, currency, equity, debt,
credit, weather, economic index, and other derivatives based on
one or more commodities for which there is no cash market or
whose price levels are not within the control of any party to
the transaction.
Under the CEA as amended by the CFMA, an ``exempt
commodity'' is ``a commodity that is not an excluded commodity
or an agricultural commodity.'' \114\ This category includes,
for example, metals and energy products.
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\114\ 7 U.S.C.A. Sec. 1a(14) (West Supp. 2002).
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The third category of commodities is ``agricultural
commodities.'' Although it is used in the definition of
``exempt commodity,'' the term ``agricultural commodity'' is
not defined. Logically, it refers to the list of agricultural
commodities traditionally within the jurisdiction of the CEA
under section 1a of the Act. It is unclear, however, whether or
not the term encompasses any additional agricultural
commodities. Generally, the regulatory framework for the
futures markets for agricultural commodities was not altered by
the CFMA.
(iii) Excluded OTC Derivative Transactions
Section 2(d) excludes from the CEA all agreements,
contracts, and transactions in ``excluded commodities'' between
``eligible contract participants'' that are not executed on a
``trading facility.'' \115\ A ``trading facility'' is defined
as a physical or electronic exchange.\116\ Roughly speaking,
this section excludes from the CEA financial derivatives that
are traded over-the-counter, not on an approved futures
exchange, among large institutions or corporations.
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\115\ 7 U.S.C.A. Sec. 2(d)(1) (West Supp. 2002). Section 2(d)(2)
provides a further exclusion for certain ``principal-to-principal''
transactions in excluded commodities on an electronic exchange. Id.
\116\ ``The term `trading facility' means a person or group of
persons that constitutes, maintains, or provides a physical or
electronic facility or system in which multiple participants have the
ability to execute or trade agreements, contracts, or transactions by
accepting bids and offers made by other participants that are open to
multiple participants in the facility or system.'' 7 U.S.C.A.
Sec. 1a(33) (West Supp. 2002). An ``electronic trading facility'' is a
trading facility that ``operates by means of an electronic or
telecommunications network'' and maintains an audit trail of bids,
offers, orders, and transactions on the facility. Id. at Sec. 1a(10).
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(iv) Excluded Swap Transactions
Section 2(g) excludes from the CEA all agreements,
contracts, and transactions ``in a commodity other than an
agricultural commodity'' between ``eligible contract
participants'' that are individually negotiated by the parties
and that are ``not executed or traded on a trading facility.''
\117\ These are referred to as ``excluded swap transactions.''
Unlike the provision excluding certain OTC derivative
transactions, which applies only to excluded commodities, which
are basically financial in nature, this provision applies to
all commodities other than agricultural commodities, which
means that agreements, contracts, and transactions in energy
and metals individually negotiated, not on an exchange, by
large corporations and institutions can qualify for the
exclusion for swap transactions.
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\117\ 7 U.S.C.A. Sec. 2(g) (West Supp. 2002).
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(v) Transactions in Exempt Commodities: Section 2(h)
Section 2(h)(1) of the CEA was meant to exempt from
regulation dealer markets and facilities, such as ``Enron
Online,'' in which one organization acts as the counterparty to
many or all of the other participants in the market. Section
2(h)(1) provides that all agreements, contracts, and
transactions in an ``exempt commodity''--which includes energy
and metals--between ``eligible contract participants'' and
``not entered into on a trading facility'' are generally
exempted from the requirements of the CEA. Unlike the swap
transaction exclusion, this exemption applies even if the
agreement, contract, or transaction is not individually
negotiated.
Some of the CEA provisions, including anti-fraud and anti-
manipulation provisions, still apply to most of these
transactions. However, the agreements, contracts, and
transactions in these commodities between ``eligible commercial
entities''--meaning those eligible contract participants that
can make or take delivery, incur commodity risks, and are
commodity dealers--are not subject to the CEA anti-fraud
provisions. This special exemption from the CEA anti-fraud
provisions essentially codifies the CFTC's 1993 energy contract
exemption from the exchange-trading and anti-fraud provisions
of the CEA.
Section 2(h)(3) is designed to allow large market
participants to trade amongst themselves on electronic trading
facilities with little government oversight. This section
provides an exemption for agreements, contracts, and
transactions involving ``exempt commodities,'' such as energy
or metals, that are executed or traded on an ``electronic
trading facility,'' and entered into on a principal-to-
principal basis between ``eligible commercial entities.''
A reduced number of CEA provisions apply to transactions on
these facilities. For example, a number of the CEA's statutory
proscriptions against manipulation apply to these transactions.
The proscription against fraud in connection with commodity
option transactions applies as well. These facilities must keep
trading records for 5 years, make such records available for
inspection by the CFTC, and provide other data upon ``special
call'' by the CFTC. In addition, if the CFTC determines that
the facility performs a significant price discovery function
for the underlying commodity, the facility must disseminate
price, volume, and other trading data in a timely manner as the
CFTC determines is appropriate. The CFTC has not yet proposed a
rule to implement this provision of the CFMA.
One of the sources of confusion following the passage of
the CFMA is the inconsistency between sections 2(g) and
2(h)(1)--whereas Sec. 2(g) totally excludes energy and metals
swaps that are individually negotiated from the CEA,
Sec. 2(h)(1) exempts energy and metals transactions from the
exchange-trading and other requirements but generally applies
the anti-fraud and anti-manipulation provisions to over-the-
counter transactions in these commodities. It is not clear
whether the exclusion provision takes precedence over the
exemption provision, or vice versa.
Moreover, to the extent that a negotiation over price can
be considered ``an individual negotiation,'' it would appear
that sections 2(g) and 2(h)(1) cover the same transactions and
are in direct conflict regarding the applicability of the CEA's
anti-fraud and anti-manipulation provisions. The CFTC staff has
told the Subcommittee staff that the CFTC interprets the term
``individual negotiation'' to include price negotiations; under
this interpretation there is no difference between sections
2(g) and 2(h)(1). Under this interpretation, all instruments
traded under 2(h)(1) on ``one-to-many'' facilities or through
dealer-brokers could be considered excluded swaps.
b. Outstanding Issues
The CFMA created a complex statutory and regulatory scheme
that perpetuates different degrees of CFTC oversight for energy
contracts, swaps, and other derivatives, depending on the size
of the parties to the transaction and the type of market in
which the contracts are traded. As other parts of this Report
demonstrate, however, as the risk-transference and price
discovery functions of the over-the-counter markets and
approved futures exchanges have become increasingly
intertwined, these distinctions make less and less sense. It
hardly makes sense to allow participants to operate in one
market in a manner that is not allowed in another.
Moreover, as other parts of this Report demonstrate, the
operation of both the OTC markets and the approved futures
exchanges can have significant impacts upon consumers and
businesses that may not trade at all on either market. Both
markets perform a vital economic function for the American
economy as a whole, and the behavior of the participants in
these markets affects not only other market participants, but
potentially millions of persons outside of those markets.
Whether or not large institutions need or desire governmental
oversight to protect themselves from each other, governmental
oversight is necessary to ensure the markets are operating
efficiently and effectively in the public interest.
Accordingly, as the OTC energy markets now perform economically
identical functions to the designated futures exchanges trading
energy contracts, the distinctions created in the CFMA between
large institutions and other types of traders, and between OTC
markets and approved futures markets, no longer is sound public
policy.
APPENDIX 3: EXHIBITS
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APPENDIX 4: ADDITIONAL DOCUMENTS
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