September 9, 2011
SPECULATION IN OIL PRICING
By: Lee R. Hansen, Legislative Analyst II
You asked for information on the role speculation plays in oil prices, including any reports by the attorney general and steps taken to address it.
Some financial and public policy analysts have come to believe that recent volatility in oil prices cannot simply be explained by the fundamental forces of supply and demand. Instead, they believe an influx of speculators into oil futures markets has artificially driven the price of oil, generally upward, in speculative bubbles. Although the attorney general's office has conducted investigations into allegations of fraud related to oil sales, it has not investigated oil speculation or issued any reports on the matter.
While a small portion of speculators' impact on pricing may be due to illegal activities such as fraud, critics of oil speculation believe that the most significant impact on oil prices stems from legal practices and “loopholes” in federal laws and regulations that are beyond the jurisdiction of state officials. Federal legislation addressing these issues include provisions in the 2008 Farm Bill and the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. Additional regulatory reforms empowered by the Dodd-Frank Act to implement speculative position limits are also ongoing. Opponents of these reforms argue that a direct link between commodity speculation and price increases has not been proven and that worldwide forces of supply and demand can sufficiently explain price fluctuations.
Unless otherwise noted, the information in this report comes from the Congressional Research Service report, “Speculation and Energy Prices: Legislative Responses,” (Mark Jickling and Lynn J. Cunningham, CRS Report RL34555, July 8, 2008)).
ENERGY FUTURES MARKETS & THE 'SPECULATIVE PREMIUM'
Energy futures markets involve two kinds of traders: (1) “hedgers,” the producers and commercial users of commodities who use the market to offset price risks by locking in current prices for future transactions and (2) “speculators” who seek to make a profit by forecasting price trends. In theory, speculators play an important and necessary role by creating a market for hedgers to offset their price risks. The market, in turn, allows hedgers and speculators to pool their information and determine prices that will clear markets and ensure efficient allocation of resources. Speculation should not necessarily lead to artificially high prices because traders dealing on faulty assumptions about supply and demand should not be able to earn profits.
Despite the theory, many experts, including some oil company executives, Organization of Petroleum Exporting Countries (OPEC) ministers, and investment bank analysts believe that recent changes in oil's supply and demand fundamentals do not justify or correlate to the commodity's drastic price fluctuations. Instead, they identified a “speculative premium” in the price of oil, which artificially raised the price beyond what the forces of supply and demand would otherwise call for. This past spring, Goldman Sachs analysts stated that every million barrels of oil held by speculators contributed to an 8% to 10% rise in the price of oil. Reuters' David Sheppard calculated that this added up to a “speculative premium” of between $21.40 and $26.75 per barrel or about a 20% increase in price (Sheppard, “Goldman Spooks Oil Speculators with Call to Take Profit,” Reuters, April 11, 2011).
Those who believe that oil prices have been artificially inflated blame a lack of regulations and the recent growth of institutional investors (i.e. pension funds, endowments, and foundations) who now invest in commodities at a larger scale than before. According to a study by Kenneth B. Medlock, III and Amy Myers Jaffe, speculators in the U.S. oil futures market increased from an average of about 20% of those holding outstanding positions prior to 2002 to about 50% in 2009 (Medlock, III & Myers Jaffe, “Who is in the Oil Futures Market and How Has It Change?” Medlock and Jaffe, James A. Baker III Institute for Public Policy, Rice University, August 26, 2009). In a June 9, 2011 speech to the Sandler O'Neill Global Exchange and Brokerage Conference, Gary Gensler, chairman of the Commodity Futures Trading Commission (CFTC), stated that only 12% of the long positions (bets that prices would rise) on West Texas Intermediate (WTI) crude oil were held by the producers, merchants, processors, and users of the commodity; thus 88% of the long positions were held by speculators (www.cftc.gov/PressRoom/SpeechesTestimony/opagensler-84.html).
Investing in commodities can make sense to diversify risks and increase investment returns, but critics believe that the collective result is an excessive inflow of money that increases prices and creates a speculative bubble. With more and more investors looking to invest in the same commodity, critics argue the price gets bid up regardless of the supply and demand related to actual consumption of the commodity. Because speculators have no stake in a commodity's fair price but instead profit through their bets on a price, they want prices to move in the direction of their bets. When speculators comprise too much of a futures market they can upset the normal tension between consumers and producers, dislodge the market from its fundamentals, and essentially create a self-fulfilling expectation of continually rising prices (Michael Greenberger, “The Relationship of Unregulated Excessive Speculation to Oil Market Price Volatility,” International Energy Forum, January 15, 2010).
GOVERNMENT RESPONSES TO OIL SPECULATION
In the wake of the dramatic increase in oil prices in 2008, the federal government tried to limit excessive speculation in the futures market. CFTC's ability to implement “position limits” on speculative traders is often seen as important to this. In general, position limits cap the number of futures contracts a speculator can own which, in theory, should limit the market impact that speculators have.
Historically, the CFTC and the regulated exchanges like the New York Mercantile Exchange (NYMEX) maintained position limits on speculative traders. However, several “loopholes” developed around 2000 which allowed speculative oil futures trading to greatly expand without CFTC regulation. The federal government's attempts to limit excessive oil speculation generally focused on closing these loopholes by: (1) ensuring that speculators cannot use foreign futures markets to avoid U.S. regulations (the “London loophole”), (2) extending regulatory control to unregulated markets (the “Enron loophole”), and (3) limiting the ability of institutional investors to dramatically impact commodity prices (the “swaps loophole”).
The London Loophole
The “London loophole” refers to differences in the oversight of regulated markets in different countries, particularly ICE Futures Europe, which is the United Kingdom's counterpart to America's NYMEX. In general, the CFTC requires foreign exchanges offering futures contracts to U.S. investors to register with it and comply with all applicable laws and regulations. Beginning in 1999, the CFTC began issuing a series of “no-action” letters to ICE Futures Europe which exempted it from CFTC requirements. By 2007, the ICE was trading significant volumes of contracts in WTI crude oil futures; contracts that presumably would have otherwise been traded on the U.S. regulated NYMEX, and subject to that market's speculative position limits.
Responding to concerns over volatile energy prices, in June 2008, the CFTC amended its no-action letter and required ICE Futures Europe to adopt U.S. position limits and accountability levels on its WTI crude oil contracts. In July 2008, the CFTC issued similar requirements for contracts on the Dubai Mercantile Exchange, which had previously received no-action regulatory waivers. The 2010 Dodd-Frank Act further addressed the loophole by requiring foreign boards of trade registering in the U.S. to establish certain rules similar to those that apply to U.S. exchanges (Gensler, June 9, 2011 speech to the Sandler O'Neill Global Exchange and Brokerage Conference).
The Enron Loophole
The “Enron loophole” refers to exemptions created by the 2000 Commodity Futures Modernization Act (P.L. 106-554) which allowed some transactions, including certain contracts for energy futures, to occur in “over-the-counter” (OTC) markets without oversight by the CFTC. In particular, the act exempted (1) energy futures contracts executed on an electronic trading facility and (2) bilateral energy futures contracts that were executed on the bilateral swaps market and not on a trading facility. Substantial volumes of trading under both exemptions developed in the years following the act (Jickling, “The Enron Loophole,” Congressional Research Service Report, RS 22912, July 7, 2008).
In October 2007, a Government Accountability Office report on the growth of OTC markets raised questions about federal regulators' ability to keep OTC markets free from fraud and manipulation. That same month, the CFTC recommended new legislation to extend its oversight into electronic trading facilities that had been exempted by the “Enron loophole.”
The Farm Bill (P.L. 110-234), passed by Congress in 2008, included provisions that generally followed the CFTC's recommendations. It extended CFTC regulation over electronic trading facilities that offer contracts in exempt commodities, including oil, if the contracts (1) had a settlement price linked to a regulated market's contract, (2) could be the subject of arbitrage trading (the simultaneous purchase and sale of an asset to profit from a difference in the price on different markets) involving exchange-listed contracts, (3) are traded in a volume that could effect other market prices, or (4) could be used as a reference point for pricing transactions in other markets. Electronic trading facilities that fall under CFTC's new jurisdiction must meet certain obligations, including adopting position limits or position accountability levels for speculators, ensuring that contracts are not readily susceptible to manipulation, publishing daily trading information, and avoiding conflicts of interest and antitrust violations.
The Swaps Loophole
The Farm Bill did not address bilateral swaps negotiated between parties that were not executed on a trading facility, thus leaving the “swaps loophole” outside CFTC regulations. According to the 2007 CFTC report, the CFTC felt that OTC bilateral swaps markets had a limited impact on other parties and markets and it would be extremely costly and difficult to monitor them (CFTC, “Report on the Oversight of Trading on Regulated Futures Exchanges and Exempt Commercial Markets,” October 2007).
Critics of the loophole note that institutional investors, who make up an increasingly large share of the market, do not generally trade directly on the regulated futures exchanges, but instead go through swaps dealers like Goldman Sachs or Morgan Stanley to use intermediaries such as commodity index funds or OTC swap contracts structured to match the return of a published index of commodity prices, like the Goldman Sachs Commodity Index. Away from CFTC regulations and position limits, institutional investors can take larger speculative positions than they would be able to take on the regulated exchanges.
In response, the 2010 Dodd-Frank Act included a provision empowering the CFTC to set position limits for certain physical commodity derivatives, including speculative bilateral oil future contract swaps. In January 2011, the commission issued a notice of proposed rulemaking on position limits and, after a year of gathering and analyzing data, plans to set and fully implement limits during the first quarter of 2012. The Dodd-Frank Act requires a majority of the CFTC's five commissioners to approve the limits before they are finalized.
Implementation of the Dodd-Frank Act and the CFTC's potential position limits continues to be debated in Washington. House Republicans proposed an 18-month delay of regulations intended to reduce risk in OTC markets, and the chairman of the House Financial Services Committee, Rep. Spencer Bachus (R-Ala), wrote to the CFTC, warning it to avoid setting overly prescriptive limits that would force firms to reduce their commodity investments. On the other hand, in May, 15 Democratic senators, Sen. Bernie Sanders (I-VT), and Sen. Susan Collins (R-ME) wrote to the CFTC asking it to unveil a position limit plan for all energy futures markets by May 23rd (Rampton, “CFTC Aims for Speculative Commodity Limits in Q1 2012,” Reuters, Jan. 18, 2011; Loder & Brush, “Energy Futures: The Risk in Speculation Limits,” Bloomberg Businessweek, Jan. 20, 2011; Doggett & Doering, “Senators Demand CFTC Tackle Oil Speculation,” Reuters, May 11, 2011).