FT Energy Source Comment: Why commodities regulation is different

Guest post by Jeff Korzenik

The Commodity Futures Trading Commission (CFTC) began hearings this week on whether or not to constrain speculation in the energy markets. The Commission is considering the broad imposition of “speculative position limits,” traditional rules which have capped the size of positions held by futures market speculators. Far from being an obscure regulatory debate, this issue is of huge importance to all Americans.  While many observers now concede that speculation has been a factor in energy pricing, it is crucial that our policymakers understand the dangers inherent in such a market condition.  At stake is the ability of our economy to recover, the potential for another systemic financial crisis, and the risks of unleashing destructive inflationary forces.

Speculation in energy commodities became largely unregulated through the Commodity Futures Modernization Act of 2000 (the same legislation that unleashed credit default swaps).  At that time, energy transactions covered by the Act were largely between commercial producers and users of crude oil, and there was little justification for government involvement.  The intervening decade has seen a radical shift in the composition of market participants, with a strong tilt towards those who do not actually use or produce oil.   Such non-commercial players have historically been defined as “speculators,” but that term no longer adequately describes the nature of their involvement.  While traditional speculators provided liquidity and aided price discovery, the new breed crowds out commercial interests and distorts prices.

Wall Street created a large and profitable business by positioning commodities as an asset class on par with stocks and bonds.  This is questionable premise – it is a strange type of investment indeed where the value is only unlocked in the destruction and consumption of that asset.   Nonetheless, many pensions, endowments and individual portfolios now include commodity exposure.  Markets like crude oil and gold may be large in the world of commodities, but are dwarfed by the size of the global bond and equity world; even a small reallocation of traditional assets into these markets can be overwhelming.  Pensions and endowments behave differently, too.  Unlike traditional traders who make short-term bets on prices going either up or down, the new participants are biased to higher prices.  These side-bets are now so large that they influence markets.  This is akin to “the tail wagging the dog,” as speculators determine price, rather than the producers and users of commodities.

Last year, in the run-up to $4 per gallon gasoline, the public debate centered on whether investment flows had any impact.  A growing consensus now accepts the reality of the influence of speculation, but question whether this type of price-moving activity should be regulated.  The discussion is complicated by the numerous stakeholders: producers want higher energy prices, consumers want lower prices, investors want the ability to enter oil contracts as inflation protection, Wall Street firms want to profit by providing that exposure, and environmentalists hope to see carbon-based fuels priced out of the market.  Too many participants in the debate benefit from this speculation or are indifferent to the regulatory outcome.

The reality is that the current levels of speculation are unequivocally bad.  From an ethical perspective, artificially high commodity prices are very different from artificially high stock prices — in the commodity arena, the impact extends well beyond the investor class.  Those innocent bystanders include the world’s poorest, who are disproportionately impacted by higher fuel costs.  From a purely utilitarian viewpoint, distorted prices inefficiently distribute resources and create unnecessary volatility, weighing down productivity and growth.  Rising prices raise inflationary expectations, further distorting decisions of investors and policymakers.  In the case of our fragile economy, high energy costs could well choke off any recovery.

While not likely, the excess speculation in the energy markets also creates a systemic risk that could spark another financial crisis.  The energy markets revolve around the assumed integrity of the standardized contracts which trade on centralized exchanges as “commodity futures.”  Even the Wall Street firms that offer customized energy contracts rely in critical ways on the public futures market.  To function, these markets rely on a predictable relationship between the price of the physical commodity and the trading price of the futures contract.  Excessive speculative volume can overwhelm the forces that hold that relationship in line.  Such a breakdown can bankrupt companies through cash flow demands linked to contract prices.  The heavy, leveraged participation of Wall Street’s derivative desks in these markets ensures that an implosion can spread from the commodity markets to the financial system.

One final argument must be addressed.  Some view the issue from the standpoint of protecting free markets.  Is constraining speculation in commodities any different than controlling investment in stocks and bonds?  However, commodities are not traditional investment assets and their markets need governance that differs from that of the capital markets.   We readily accept limitations in capital market transactions:  prohibitions on insiders trading, for example.  Commodity markets have different but equally important rules, rules meant to ensure that speculators can’t overwhelm efficient market pricing.  It’s time for our regulators to enforce them.

Jeff Korzenik is Chief Investment Officer of Caturano Wealth Management and author of the financial blog, “(in)efficient frontiers” (www.inefficientfrontiers.com)