Unregulated energy-market speculation is costing you money

By Henry Banta
henrybanta@aol.com

Energy markets face a greater risk of manipulation these days. Two factors have contributed to this increased risk. The first is the dramatic increase in commodity trading, particularly unregulated trading on the energy markets. The second is the structural change in the domestic refining industry resulting from mergers.

The recent hearings and reports by the Senate Subcommittee on Investigations have highlighted the effects that market manipulation can have on the gasoline and natural gas futures markets.  Last year the Senate Permanent Subcommittee on Investigations issued a report on “The Role of Market Speculation in Rising Oil and Gas Prices.”  The Report found that speculative money has been a major factor in the rapid rise in oil and gas prices. By some estimates, it has accounted for as much as $20-$25 out of the $70 a barrel price for crude oil during 2006.  Recently the Subcommittee issued a report on “Excessive Speculation in the Natural Gas Market.”  This report found that a single hedge fund, Amaranth Advisors LLC, dominated the domestic natural gas market last year, and that its trading activities distorted prices, increased volatility, and ultimately inflated costs to consumers.

Both of the Subcommittee reports focused on the lack of regulation or scrutiny of the trading in the energy markets.  The Commodity Futures Trading Commission (CFTC) does regulate domestic commodity exchanges, which until quite recently accounted for virtually all of the trading of futures contracts. Large transactions on the NYMEX, for example, are subject to CFTC reporting requirements.  But traders wishing to avoid regulation or reporting requirements can easily do so.

In its glory days Enron lobbied Congress for, and got, an exemption from CFTC regulation for the trading of energy futures on over-the-counter electronic exchanges.  Contracts traded on these exchanges are often called “futures look-a-likes.”  They differ from contracts traded on regulated exchanges only in that they are beyond CFTC scrutiny.  There is no reporting requirement, even for very large transactions.

This past year another loophole opened when the CFTC permitted the Intercontinental Exchange (ICE) to use trading terminals in the United States for trading crude and refined products on its futures exchange in London.  In effect, this permitted anyone wishing to trade petroleum in the U.S. to avoid regulation or reporting by simply routing its trades through London.

The Subcommittee’s hearings on natural gas trading demonstrated the effect of this loophole.  When, in August 2006, Amaranth was ordered by NYMEX (under rules designed to prevent excessive speculation) to reduce its holdings of natural gas contracts, it promptly did so.  Amaranth then increased its holdings of such contracts on the ICE where they were beyond the reach of CFTC regulation and reporting requirements, completely frustrating the intent of the NYMEX order.  But for Amaranth’s ultimate collapse, no one would have known.

The second set of facts giving rise to concerns about price manipulation relates to the fairly high concentration in the domestic refining industry.  Over the last several decades a series of mergers has reduced the number of competitors in the refining industry. Concentration is particularly high when viewed from a regional perspective. This increase changes the way the industry responds to accidents or other supply interruptions. For instance, as the smaller regional refiners have disappeared and the nation has become more dependent on larger refineries, the consequences of an unanticipated event have become more severe. Secondly, it has changed the industry’s incentives, not just in the way it responds to supply interruption, but in the way it manages supply generally. Over the past few years the gasoline market has exhibited considerable price volatility, much of it in response to relatively minor fluctuations in supply from the refining industry.  Major interruptions have resulted in spectacular price increases.

This price volatility has been aggravated by a decrease in the refiners’ working inventory of refined products.  As was pointed out  on this Web site by Peter Ashton on June 15, 2007, for over 15 years the industry has been reducing its working inventory of gasoline, going from around 30 days of supply in 1990 down to 22.6 days, barely above the 20 day supply necessary to keep the system functioning.  This has created a situation where even a brief supply interruption can produce a serious price spike.

Because they trade considerable volumes of crude oil and refined products among themselves, refiners have excellent insights into the supply positions of their competitors.  Perhaps more importantly, because each refiner knows its own schedule for maintenance and can make a pretty good guess at that of their rivals, each refiner is in a uniquely advantageous position regarding the industry’s supply position.  One might even suggest that they are what in other markets would be called “insiders.”  Refiners are in a position to bet on a tight market and to make it a good bet.  Worse, they could do it in a completely unregulated and opaque market. 

Adding to the almost total lack of transparency in the unregulated commodity markets is the array of trading devices available.  A refiner who wished to place a bet on a gasoline shortage need not do anything so crude as taking a long position in gasoline on the futures market.  There are a host of complex hedging devices available which could produce the same result in far less conspicuous way.  And if done through the ICE, or a similar off-shore market, no one would ever know.

There is no evidence that any such thing has happened.  The point is that if it did, we might never know.  Oilmen are more no greedy or unprincipled than the common run of mankind.  On the other hand it would be a reckless policy to expose them to an excessive amount of temptation.

Henry M. Banta is a partner in the Washington, DC, law firm of Lobel, Novins & Lamont. E-mail: henrybanta@aol.com

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