The dramatic surge in oil prices—including a $16-per-barrel jump in just two days last week—has left Washington regulators scrambling to exert new oversight on futures trading in oil and other commodities. The U.S. regulatory agency's abrupt shift toward more rigorous oversight in the past two weeks also represents a stark example of how the pinch from high gasoline prices has changed the political landscape and made energy traders prime suspects in congressional inquiries.
As recently as May 20, the U.S. commodities regulator, the Commodity Futures Trading Commission (CFTC), insisted at a Senate hearing that speculation was not causing the rapid spike in energy prices. The CFTC's chief economist, Jeffrey Harris, testified that the agency found that speculation and manipulation are not causing energy prices to surge. He said that instead prices are being driven "by powerful economic fundamental forces and the laws of supply and demand." Nine days later, after further pressure from Congress, the agency announced steps aimed at more oversight of energy futures trading.
Among the measures (BusinessWeek.com, 5/30/08):
• A new information-sharing agreement with Britain's commodities regulator, the Financial Services Authority (FSA), to gather information on large positions of the benchmark West Texas Intermediate (WTI) contract.
• A proposal to consider reclassifying investment banks such as Goldman Sachs (GS) and Morgan Stanley (MS) as speculators, which would subject them to trading limits from which they're currently exempt.
• An investigation of the crude oil trading market dating to December, 2007. On May 30, The Wall Street Journal (NWS) reported that the CFTC has also expanded an investigation into allegations of short-term manipulation of crude oil prices through a price-reporting system overseen by Platts, the energy data unit of The McGraw-Hill Companies (MHP), which also owns BusinessWeek. The CFTC won't confirm such a probe, and Platts has declined to comment.
The agency's pronouncements come as oil prices spike to new record highs. On June 6, oil prices jumped to a record settlement of $138.54, after touching an intraday record of $139.12. The 13.3% rise—$16.24 per barrel—on June 5-6 marked the biggest two-day gain for oil in trading history. Meanwhile, gas prices reached a new record national average of $4.005 a gallon on June 8.
Critics say such changes are long overdue. "The CFTC has been deregulating itself out of existence," says Michael Greenberger, a law professor at the University of Maryland and former head of the CFTC's Div. of Trading & Markets. "The only way to permanently deflate the [commodities] market is to ensure more aggressive oversight." If the CFTC took the next step of requiring all U.S. crude trades to be subject to CFTC regulation and trading limits, oil prices would drop by 25% "overnight," says Greenberger.
The CFTC declined to comment for this article, but on a June 3 conference call with reporters Acting Chairman Walter Lukken explained the recent actions: "In a free-market society we want to encourage access to markets. However we want to make sure that the funds coming into the markets aren't distorting them." To be sure, the CFTC has not yet made any regulatory changes. But its recent steps indicate a more serious public engagement with the issue of speculation, which could ultimately lead to more regulation.
More Regulation Needed?
Several changes over the past decade have relaxed the agency's oversight of commodities markets. The Commodity Futures Modernization Act of 2000 (CFMA) allowed energy commodities for the first time to be traded on deregulated "exempt commercial markets," meaning exchanges exempt from CFTC or any other U.S. government oversight. This law was a departure from the Commodity Exchange Act of 1936, which had confined commodities trading to CFTC-regulated exchanges.
Besides opening the door for unregulated, off-exchange trading, the CFMA excluded what are known as "swaps" from regulation. As institutional investors like pension funds and university endowments have sought a hedge against inflation and alternatives to a shaky stock market, they have entered into swaps agreements with investment banks that allow the banks to trade in futures markets on their behalf. Under the 2000 law, the CFTC exempts these banks from position limits to which other speculators must adhere.
As a result, investment in index funds tied to commodities, such as the Goldman Sachs Commodities Index (GSCI), rose from $13 billion in 2002 to $260 billion in 2007. These investors take long-term positions—which are exclusively long—in the futures markets. Such funds tend to put upward pressure on commodities prices (BusinessWeek.com, 5/21/08).
At a June 4 Senate hearing, the CFTC's Lukken acknowledged the new investments. "A lot of money is flowing into [commodities] markets, potentially creating a bubble. …We don't have the regulatory tools needed to spot that sort of situation," he said.
If the CFTC decides to subject investment banks trading swaps to speculative trading limits—currently 3 million barrels of WTI crude oil for front-month trades—oil prices could deflate significantly, say analysts. "If [the CFTC] forces trade limits on these funds, commodity index traders will have to pull out of this market," says Stephen Schork, an energy consultant in Villanova, Pa., and editor of The Schork Report, a daily energy newsletter. "The [commodities] bulls would be in for a world of hurt." Schork says such a correction would send oil prices back to the $80-$100 range.
The "London-Dubai Loophole"
Some also want the CFTC to address what Senator Maria Cantwell (D-Wash.) and others call the "London-Dubai loophole," which allows some U.S. energy trading to be overseen by foreign boards of trade. A growing proportion of the U.S. contracts for crude oil futures are operated by ICE Futures Europe, a London subsidiary of the Atlanta-based InterContinentalExchange (ICE). In January, 2006, InterContinentalExchange announced it would trade West Texas Intermediate crude oil contracts. Under a "no action" letter issued by the CFTC, these trades fall under the regulatory supervision of the Financial Services Authority of Britain. Today, an estimated 30% of West Texas Intermediate trading is now done through ICE Futures Europe, and is not regulated by the CFTC.
The CFTC has issued "no action" letters to 16 other foreign exchanges, exempting itself from regulating a variety of contracts in specified circumstances. In May, 2007, the agency issued such a letter to the Dubai Mercantile Exchange, allowing it to install trading terminals in the U.S. but be regulated by the Dubai Financial Services Authority. On May 16, 2008, the Dubai exchange announced that in partnership with the New York Mercantile Exchange (NMX), it has received CFTC approval to begin trading WTI contracts.
With these allowances for foreign boards of trade, critics worry that over time, an increasing proportion of WTI contracts will be subject to no CFTC oversight. "Roll up your sleeves, assert the national authority of the United States, and regulate these markets," Mark Cooper, research director for the Consumer Federation of America, a nonprofit advocacy group, told the Senate Agriculture Committee on June 3.
Also testifying before that committee, Greenberger suggested that simple adjustments to commodities regulation could remedy what he views as an artificially accelerated price runup. "If we go back to the way the market was regulated on Dec. 20, 2000, 25% of the [oil] price would disappear," he says.
With prices rising, speculation remains a hot topic in Washington. On June 11 and 12, the CFTC is convening its own conference on "international energy market manipulation," and on June 23 the House Committee on Energy & Commerce plans another hearing, titled "Energy Speculation: Is Greater Regulation Necessary to Stop Price Manipulation?" That committee's chairman, Representative Bart Stupak (D-Mich.), says he and others plan legislation to target speculation through swaps, foreign exchanges, and over-the-counter trades. One proposal would subject ICE Futures Europe to the same oversight as the Nymex.
Other proposals are circulating in Washington (BusinessWeek.com, 5/15/08). In May, Senate Majority Leader Harry Reid (D-Nev.), Senator Jeff Bingaman (D-N.M.), and others unveiled the Consumer-First Energy Act, which would mandate higher cash collateral for energy-futures trading and ban traders of U.S. crude oil from routing their transactions through offshore markets. And Representative John B. Larson (D-Conn.), is expected to propose legislation that would go a step further, effectively banning over-the-counter energy futures trading by those who don't take physical delivery of the commodity.
Greenberger says that given the heated political climate, he fears that misguided propositions that would distort the market—like banning speculators from commodities markets entirely—could win support. "The American consumer is so beaten up, [Congress] may have to resort to more drastic measures or the sky will fall."