Thursday, August 21, 2008

Still feeling manipulated

Contrary to the preliminary report that it issued last month, the Commodity Futures Trading Commission (CFTC) is uncovering more evidence that speculation has played a noticeable role in oil markets.

First there was the embarrassing revelation just two days after the report was released that the CFTC was going after a holding company and two of its subsidiaries for manipulating the prices of oil futures contracts. So, contrary to the report, there was direct evidence that a small number of traders had been able to move prices.

Today, the Washington Post reports that a few large speculators hold enormous positions in the futures markets.

Even more surprising to the commodities markets was the massive size of Vitol's portfolio -- at one point in July, the firm held 11 percent of all the oil contracts on the regulated New York Mercantile Exchange.

The discovery revealed how an individual financial player had gained enormous sway over the oil market without the knowledge of regulators. Other CFTC data showed that a significant amount of trading activity was concentrated in the hands of just a few speculators.

...CFTC data show that at the end of July, just four swap dealers held one-third of all NYMEX oil contracts that bet prices would increase. Dealers make trades that forecast prices will either rise or fall. Energy analysts say these data are evidence of the concentration of power in the markets.
Concentration is seldom good news for a market. The problem here has been a series of steps that have deregulated commodity futures markets.

Futures markets exist to provide some stability to buyers and sellers who need to exchange goods over time. The markets allow each side to contract prices for their transactions sometime into the future, removing some of the uncertainty associated with market swings. During the most recent oil price rise, several airline companies used futures contracts to great advantage to lock in moderate fuel prices.

Prior to the early 1990s, producers and users of commodities could conduct unlimited transactions in these markets, but speculators and pure traders were restricted to hold small positions. An administrative reinterpretation of the rules during the first Bush administration, removed the transaction restrictions for large investment houses.

In 2000, Congress passed and President Clinton signed the Commodity Futures Modernization Act. Buried in this act was a provision introduced by Sen. Phil Gramm on behalf of Houston-based Enron to allow energy trading to be conducted in over-the-counter markets, outside the reach or view of regulators. These markets are sometimes referred to as "dark markets." A tepid provision to narrow this loophole was enacted over President Bush's veto this summer.

A sensible solution would be to extend a consistent regulatory umbrella over all energy markets--that is, to completely repeal the Enron loophole. The current system of regulating some markets but not others is unfair to established markets and leaves the door open for abuse and manipulation. Another sensible solution is to require investors to put up more cash for their positions; currently much of the trading in these markets is highly leveraged, which increases the chances of both bubbles and spectacular crashes.

Looking forward, Sen. Obama has called for closing the Enron loophole, while Sen. McCain, who has been advised by Phil Gramm, continues to support it.