Energy Futures: The Risk in Speculation Limits

The sun was starting to rise as Fiddle Cote steered his 7,500-gallon truck loaded with heating oil out of a terminal north of Albany, N.Y. He headed east past frost-covered fields toward Bellows Falls, Vt., where the oil would be delivered to customers' homes. The day before, on Nov. 10, heating oil had reached $2.44 a gallon, a price spike that Cote blamed on speculators. "Let them stop speculating for one year," Cote says, "and I guarantee you the price will tank."

Since then, heating oil prices have continued to climb, hitting $2.66 on Jan. 19, the highest mark since October 2008. That price jump, not to mention crude oil near $91 a barrel, has sparked a fresh outcry against speculators. Last year's Dodd-Frank financial reform law lets the Commodity Futures Trading Commission restrain speculators, and the agency on Jan. 13 began the process by proposing a complex array of limits on investors in energy contracts.

Trouble is, CFTC Chairman Gary Gensler may lack the votes needed to issue final rules, and his agency has just begun to gather the data it needs to fine-tune and enforce some restrictions. On top of that, newly empowered Republicans in Congress say the CFTC hasn't shown speculation is a problem and is moving too fast. The CFTC says the final limits, if adopted, wouldn't take effect until early 2012. Some Republicans question the need for new rules at all.

Since the mid-1980s, traders have had two ways to bet on energy. They could buy futures on regulated exchanges, where standard contracts determine the price and date of delivery. Or they could negotiate privately for unregulated, look-alike contracts called swaps. Until now, swaps were like a black box, beyond the view of the CFTC. The absence of restrictions allowed investors to pour into the oil markets, says Peter Beutel, president of trading advisory company Cameron Hanover in New Canaan, Conn. "Oil has developed a lot of the same characteristics as gold," Beutel says. "It isn't supply and demand that's driving prices. It's the interest in oil as an asset."

The agency, however, has little idea how many swaps there are, who's involved, and what they're worth. How can the CFTC limit the share of the market one firm can control when no one knows how big the market really is? "That market is completely dark to us," says Scott D. O'Malia, the newest CFTC commissioner and one of two Republicans on the five-member panel. Getting that information from banks, hedge funds, and refineries is tough, he says.

Limiting speculators has been hotly debated since 2008, when oil hit a record $147.27 a barrel. Gensler helped secure his confirmation to lead the agency in May 2009 by pledging to combat "excessive speculation." His dilemma: Democratic senators want a crackdown, but House Republicans don't and can retaliate by cutting his budget, which Gensler wants Congress to increase to $261 million from $169 million. Much of the increase would go toward hiring 400 more people to implement the Dodd-Frank law. Already, Representative Spencer Bachus (R-Ala.), the new chairman of the House Financial Services Committee, warned the CFTC in a Dec. 16 letter to avoid setting overly prescriptive speculation limits that might force firms to reduce their commodity investments. Speculators have become "scapegoats" for rising prices, says Terry Duffy, executive chairman of CME Group (CME), owner of the New York Mercantile Exchange where oil contracts trade. "The fundamentals will always dictate what the price should be," he says.

To win political support, the CFTC's Jan. 13 proposal is modest, says trading consultant Beutel. The regulator estimated that its proposed caps on spot month contracts—the nearest delivery month—would affect only 40 energy traders a year. Limits on futures and swaps in all other months beyond the spot month would affect just 10 traders. The agency counted 418 large oil traders in the week ended Jan. 4, and 175 in natural gas.

Gensler might not have the three votes needed to impose even those limits. Democratic Commissioner Michael V. Dunn, whose term expires in June, may be the swing vote. At the Jan. 13 meeting, Dunn said there's no "reliable economic analysis" that proves excessive speculation is affecting markets. "My fear is that, at best, position limits are a cure for a disease that does not exist," Dunn said. "Or at worst, a placebo for one that does."

The bottom line: The CFTC's push to limit commodity speculation faces opposition from House Republicans who now share control over the agency's budget.

    Before it's here, it's on the Bloomberg Terminal.