Market Speculation and Energy Prices:

A Congressional Perspective

Presentation to UH-GEMI Energy Trading Conference

January 25, 2007

Dan M. BerkovitzCounsel

Permanent Subcommittee on InvestigationsUnited States Senate(Senator Carl Levin)

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Outline of Presentation

• I. What is the Senate Permanent Subcommittee on Investigations?

• II. PSI Report (2006) on Speculation and Energy Prices

• III. Prospects for Legislation Affecting Energy Trading

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Senator Harry Truman’s investigation during WWII of war profiteering led to the creation in 1948 of the Senate Permanent Subcommittee on Investigations (PSI).

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PSI Energy Price Investigations

• In the mid-1970s, PSI jurisdiction expanded to include energy supplies and prices under chairmanship of Senator “Scoop” Jackson.– Investigated national security implications of Arab oil embargo– Investigated structure of the oil industry and role of oil majors in pricing

• Recent investigations under Chairman and Ranking Minority Member Carl Levin: – Gasoline price report and hearings (2002).

– Report on oil prices and regulation of energy markets (2003).

-- Report on the role of speculation in rising energy prices (2006).

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2006 Report: Findings on Speculation

1. There has been a large increase in the amount of financial speculation in energy markets.

2. This increase in speculation contributed to increased prices.

3. This increase in speculation shifted traditional price-inventory relationships.

4. Electronic markets involve the trading of standardized, cleared contracts that are functionally equivalent to futures and perform a price discovery function.

5. The disparity in regulation of various energy markets (Designated Contract Markets vs. Exempt Commercial Markets) impedes market oversight and the ability to prevent price manipulation.

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What is Speculation?

• A speculator “does not produce or use the commodity, but risks his or her own capital trading futures in that commodity in hopes of making a profit on prices changes.” --CFTC.

• Potential benefits of speculation: – Increases liquidity.– Commercial entities are able to transfer risk of price changes.– Finances storage.

• Potential disadvantages:– Excessive speculation can cause prices to deviate from the

fundamentals of supply and demand. – Increased volatility increases costs of hedging and makes it

more difficult for commercial participants to determine when to hedge.

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CFTC Has Mission to Prevent Excessive Speculation

• Section 4a(a) of the Commodity Exchange Act directs the CFTC to establish limits on speculation:“Excessive speculation in any commodity under contracts of sale of such commodity for future delivery made on or subject to the rules of contract markets or derivatives transaction execution facilities causing sudden or unreasonable fluctuations or unwarranted changes in the price of such commodity, is an undue and unnecessary burden on interstate commerce in such commodity. For the purpose of diminishing, eliminating, or preventing such burden, the Commission shall, from time to time, after due notice and opportunity for hearing, by rule, regulation, or order, proclaim and fix such limits on the amounts of trading which may be done or positions which may be held by any person . . . .”

• CFTC imposes speculative limits on energy futures just prior to contract expiry to ensure orderly trading near expiry.

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Speculative Limits for Energy Contracts

MarketNet All Months Combined

Net Single Month (Other Than Spot)

Spot Month

Crude Oil None None 3,000 for last 3 days

Reformulated Unleaded Gasoline

None None 250 for last 3 days

RBOB Unleaded Gasoline

None None 1,000 for last 3 days

Natural Gas, Henry Hub

None None 1,000 for last 3 days

Natural Gas, Basis Swaps

None None 500-2,500, depending on contract

No. 2 Heating Oil None None 1,000 for last 3 days

Electricity None None 500-3,000, depending on contract

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Increase in Speculation

• Commodity Indexes– Goldman Sachs estimates that approx. $110 billion now invested in GSCI

and other indexes, up from $70 billion in 2005 and $15 billion in 2003. – Index investments are generally long investments.– Marketed as portfolio diversification. – Pension funds, large institutions, and hedge funds are major investors.

• Hedge Funds– In 2006, NY Times reported an estimate of at least 450 hedge funds with

$60 billion in assets focused in energy and environment; including 200 devoted exclusively to energy.

– News reports of energy hedge fund collapses in 2006 indicate some funds use highly speculative strategies.

– Absence of reporting requirements makes increased hedge fund investment difficult to quantify.

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Increase in Energy Trading: Increase in Open Interest in Futures Contracts

Crude Oil and Natural Gas Open Interest1998 - 2006

0

500

1000

1500

2000

2500

Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06

Number of Contracts (thousands)

Crude Oil

Natural Gas

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Increase in Non-Commercial Trading in Natural Gas Futures

Natural Gas Futures and OptionsCommercial and NonCommercial Positions

1998 -2006

0

100

200

300

400

500

600

700

800

900

1000

Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06

Non-Commercial Long

Non-Commercial Short

Non-Commercial Spread Positions

Commercial Long

Commercial Short

Number of contracts (thousands)

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Increase in Non-Commercial Trading in Crude Oil Futures

Crude Oil Futures and OptionsCommercial and NonCommercial Positions

1998 - 2006

0

200

400

600

800

1000

1200

1400

Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06

Non-Commercial Long

Commercial Long

Non-Commercial Spread Positions

Non-Commercial Short

Commercial Short

Number of contracts (thousands)

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Increase in Crude Oil Prices

Crude Oil Prices(Price of NYMEX Near-Month Contract)

0

10

20

30

40

50

60

70

80

90

Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07

$/barrel

Iraq war begins

9-11-01

Katrina

July 14, 2006$77.03

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Crude Oil Prices Hit Record Highs Despite High Inventories

U.S. Crude Oil Inventory (excluding SPR)January 1998 - December 2006

250

270

290

310

330

350

370

Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07

crude oil inventory(millions of barrels)

May 29, 1998347 million barrels$15

April 9 1999345 million barrels$16.45

May 12, 2006347 million barrels$72

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Speculation: A Contributor to High Oil Prices

• “With the demand from the investment community, oil prices have moved up sooner than they would have otherwise.” –Former Federal Reserve Chairman Alan Greenspan (2006)

• “Senator, the facts are—and I’ve said this publicly for a long time—the oil prices have been moving steadily up for the last two years. And I think I have been very clear in saying that I don’t think that the fundamentals of supply and demand—at least as we have traditionally looked at it, have supported the price structure that’s there.” --Lee Raymond, Chairman and CEO, ExxonMobil (2005).

• “There has been no shortage and inventories of crude oil and products continue to rise. The increase in price has not been driven by supply and demand.” --Lord Browne, Chief Executive of BP (2006).

• “In summary, increased purchases of long-dated crude lift the forward price curve. The rise in prices is reflected back to contracts maturing in a few months. . . . [T]he impact of increasing stocks has been overwhelmed by the strong demand for forward crude, which has added as much as $24 per barrel to prices.” --Philip Verleger, Petroleum Economist

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Speculation Shifted the Relationship Between Crude Prices and Inventory

Figure 6Prices v Total US StocksJanuary 1998 - May 2006

0

10

20

30

40

50

60

70

80

260 270 280 290 300 310 320 330 340 350 360

1998 - 2003

2004

2005

2006

Price of U.S. crude oil, $/barrel

Total U.S. Crude Oil Inventory, Millions of Barrels

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Speculation Helped Elevate Crude Oil Forward Curves

Forward Price Curves1999 - 2006

-6

-4

-2

0

2

4

2 3 4 5 6 7 8 9 10 11 12

1999

2000

2002

2003

2004

2000

2004

2001

2006

2006

2005

Co

nta

ng

oB

ackw

ard

atio

n

Difference in Price from First Month Contract (dollars)

Number of Months in the Future

1999

2002

2001

2003

2005

For years 1999-2002, the dates reflect the forward curve as of December 1. For other years, the dates reflect the forward curve as of Dec. 2, 2003; Dec 6, 2005, and April 1, 2006.

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Speculation Helped Elevate Natural Gas Forward Curves

Natural Gas Futures PricesForward CurvesJune, 2002-2006

0

2

4

6

8

10

12

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42

6/17/2002 6/16/2003 06/18/2004 06/15/2005 06/20/2006

dollars per MMBTU

months forward

2006

2005

2004

2003

2002

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Increase in Speculation on ICE(Intercontinental Exchange)

ICE Participants

Year ended December 31, OTC Participants Trading (as % of total commissions)

2003 2004 2005

Commercial companies (including merchant energy)

64.1% 56.5% 48.8%

Banks and financial institutions 31.3% 22.4% 20.5%

Hedge funds, locals and proprietary trading shops

4.6% 21.1% 30.7%

Source: ICE, Form 10-K (2006).

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Disparity in Regulation Between NYMEX and ICEFutures and Exempt Commercial Markets:

Differences in Oversight to Prevent Price Manipulation

Does the Measure Apply to the:

Measure to Prevent Price Manipulation

Futures Market

Exempt

Commercial Market

CFTC Market Surveillance Program

· CFTC staff monitoring of daily trading reports

Yes

No

· Weekly reports and reviews for expiring contracts

Yes

No

· Option of special data call by CFTC

Yes

Yes

Large Trader Reporting

· Large trader reporting by clearing members

Yes

No

· Large trader reporting by exchanges

Yes

No

· Filing of information about trading accounts by

traders

Yes

No Core Principles for Exchange Operations

· Exchange is responsible for monitoring compliance

with market rules

Yes

No · Exchange can only list contracts for trading that

are not readily susceptible to manipulation

Yes

No · Exchange must monitor trading to prevent

manipulation, price distortion, and disruption of the delivery or cash-settlement process

Yes

No

· Position limits for speculators to reduce the

potential threat of manipulation or congestion

Yes

No · Emergency authority, in consultation with the

CFTC, to liquidate positions, suspend trading, or impose special margin requirements

Yes

No

· Daily submission of trading information to CFTC

Yes

Limited

· Daily publication of trading information

Yes

Limited

· Exchange must keep records of trading

Yes

Yes

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PSI Report Recommendations

• Require Large Trader Reports for futures “look-alike” trades (e.g., ICE Henry Hub natural gas swaps) on electronic exchanges.

• Require Large-Trader Reports for U.S. energy commodities traded from a domestic terminal on a foreign board of trade (e.g., WTI on ICE Futures).

• CFTC should issue regulations to increase dissemination of daily trading from the ICE electronic exchange. – CEA §2(h)(4)(D) requires CFTC to issue regulations to provide for public

dissemination of trading data (e.g., volume, open interest, price data) for electronic trading facilities that perform a price discovery function in the cash market for the commodity.

• Close “Enron loophole”.

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Subsequent Relevant Developments

• CFTC-FSA agreement to share data.– The agreement is vague as to the

extent of sharing of real-time trading data.

• CFTC modification of COT reports.– COT reports provide key information

about speculative investments in commodity futures but have not kept pace with market changes.

– New COT report provides Increased detail on nature of non-commercial hedging.

– Changes apply only to COT reports for agricultural commodities.

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Senate Legislation

• S. 2642 (109th Congress) (Sens. Feinstein, Snowe, Levin, Cantwell):

– Would require Large Trader Reports for futures-like trades on electronic markets

– Would require Large Trader Reports for trading within the U.S. of U.S. energy commodities on foreign exchanges

• Anticipate re-introduction of the same or similar bill.

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Support for S. 2642

•   Agricultural Retailers Association (ARA)•   Air Transport Association (ATA) of America•   American Public Gas Association (APGA)•   American Public Power Association•   Consumer Federation of America•   Consumers Union•   Industrial Energy Consumers of America•   National Association of Wheat Growers•   National Barley Growers Association•   New England Fuel Institute (NEFI)•   Pacific Northwest Oil Heat Council•   Petroleum Marketers Association of America (PMAA)•   Petroleum Transportation and Storage Association•   30 State Petroleum Marketing Associations

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House Legislation

• Previous Congress: House-passed CEA reauthorization bill contained an amendment sponsored by Rep. Graves– Requires CFTC to review “significant and highly unusual” price

changes in natural gas futures contracts to determine whether manipulation has occurred.

– Enhanced recordkeeping and reporting for all natural gas positions.

• Current Congress: H.R. 594 (Rep. Stupak + 18 cosponsors)– Eliminates “Enron loophole.”– Recordkeeping and reporting for large trades in all electronic

and OTC energy markets that perform a price discovery function.

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References

• PSI Report on Speculation http://hsgac.senate.gov/index.cfm?Fuseaction=Subcommittees.Home&SubcommitteeID=11&Initials=PSI(scroll down the page)

• Data sources: NYMEX, CFTC, ICE, EIA.

• dan_berkovitz@hsgac.senate.gov