Slapping position limits on traders in OTC energy markets would be punishing the innocent, argues Michael Cosgrove of GFI Group. Markets do need to operate under rules, but rules must be based on understanding, he contends – in an article responding to the editorial published in the last issue of FOW.

I read the editorial in FOW’s July/August number with some interest and was struck by two things. First, the thoughtfulness of the consideration and second, the anonymity of the apparent culprit: “markets”.

As I have earned my living in the energy markets for the past 28 years it seemed to me that this message was targeted to me as much as anyone and so I would like to join this discussion.

I am a wealthy American, inasmuch as my family and I do not want for the basic necessities of life. Having said this, there is no disputing that price rises in the past few years in many basic commodities have created hardship for many people globally.

A day does not go by when I do not think that I could have been born elsewhere under very different conditions – a Tutsi in Rwanda, a black man in apartheid South Africa or the son of a white farmer in Zimbabwe. So while I have not changed my diet in response to rising food prices I believe that many people have.

For any decent, ethical person the question is not whether action should be taken but what kind of action should be taken.

Whatever action we take must be based upon a firm understanding of the reality of the condition we seek to confront. We need to understand what is happening and (as best we can) why it is happening.

I have read numerous statements in the press by our elected officials that are either statements of ignorance or a conscious act to inflame voters in an attempt to enhance their political status as saviours of the people. These self-serving statements are not helpful and only serve to distract us from a meaningful consideration of the issues.

Judge, jury and hangman

It is true that in regard to the Commodity Futures Trading Commission the gloves have come off, perhaps even more than the author of the editorial realised.

While the CFTC is holding hearings to gather information upon which to consider implementing new or more restricted position limits, it has already sent messages to Nymex/CME that resulted in Nymex/CME deciding that it had no other practical course of action but to implement position limits on cash-settled natural gas swaps.

Upon receiving this instruction, on June 5 and June 12 Nymex/CME issued two market regulation advisories to members, implementing strict new limits on these swaps. Nymex/CME’s actions in turn will force ICE to adopt the same limits.

To draw a simple analogy, it is as if the CFTC, as judge, has publicly proclaimed that the accused will be given a fair hearing in the coming months, without bothering to tell us that it hanged the accused last month.

I guess that I do not really blame the CFTC for this. They are just under terrible pressure to be seen as the new sheriff in town – cleaning up the bad guys – whether the bad guys exist or not.

At this point I have to make a disclosure. I run the commodities business for GFI Group, a global interdealer broker. While we do not do any business with index funds and I am unable to detect any financial benefit to my company by the activity of any index fund, I do earn more money when the businesses that I run earn more money – and that tends to happen when market volumes are higher. So I have a biased desire to see higher volumes of trading in the wholesale markets that we serve.

Notwithstanding this, I think I can be pretty fair in identifying some issues that we need to understand before we act.

Let the data speak for itself

There is scant empirical evidence linking volumes of speculation to the price of energy. Whatever we may feel about this, the vast preponderance of evidence fails to support the connection.

The only two reports of which I am aware that claim the existence of a relationship between speculation and price were prepared by Senator Carl Levin’s Permanent Subcommittee on Investigations. Having read these reports, I believe that the conclusions were written before the research commenced.

I have read the Government Accountability Office report published on January 9 this year and I have reviewed the studies done by Dr Scott Irwin at the University of Illinois, the CFTC and the CME. Each report concludes that there is no statistically significant relationship between speculation and prices.

I am not suggesting that the presence of these studies and the absence of comparably objective contradicting studies mean that we should abandon consideration of reregulating our markets – it is prudent to examine the rules governing markets and revise them as necessary.

To err is human

Markets comprise lots of human beings. Human beings are never always rational – not one of us. The great economist and investor Benjamin Graham said that in the short term markets are voting machines, while in the long term they are weighing machines.

I firmly believe that this applies to our energy markets, as much as it does to the equity or debt markets, to which he most likely referred.

Like every other market, commodities sometimes dramatically overshoot a rational equilibrium that we would otherwise expect to result from the forces of supply and demand. This probably happens to some degree in all markets. It certainly happened in the real estate markets. However, in spite of the catastrophic damage done by real estate speculation, no one has suggested position limits there.

In regard to the dramatic price spike in crude oil in 2008, it is worth noting that sometimes very small changes in supply versus demand can cause very large changes in the price.

Consider this example. You and I and 19,998 other people are on an island. On this island food can only be sold on an annual basis in one-person units and cannot be shared. There are 20,001 units of food. One unit is going to go to waste. What do you bid for your food for the coming year?

Now imagine that there are 19,999 units of food. Someone is going to starve to death. Now what will you bid to ensure that no one in your family is the one that is going to die of starvation? Demand is unchanged and supply has changed by two in 20,000 – one hundredth of 1% – and yet we have no difficulty imagining a significantly higher mean price being paid by the bidders.

Sometimes small changes in supply or demand, or the anticipation of them, can dramatically alter the price of a commodity. In 2008 the global economy was booming, the “currency” of oil (the US dollar) was very weak and there was a pervasive belief that India and especially China would pay whatever it took to secure energy. Our own government was filling the Strategic Petroleum Reserve at prices prevailing at the time. The world was very different then.

Did the crude market operate rationally in 2008? I don’t think so, but it did operate efficiently and fairly.

I do not believe that markets always know best. Markets need rules and police and courts to ensure that they are fair. Even then, at times they are not going to be remotely rational, but we must not pretend that there is any kind of legislation imaginable that will ensure that markets are always rational. It’s impossible. No matter what we do, markets will sometimes reflect the gross imperfections of their participants.

It is also worth remembering that oil does not have a history of price stability. Oil has been a boom or bust market from the beginning.

Again, I am not suggesting that we should do nothing, only that we should not attempt to “solve the problem” of occasionally irrational markets by effectively closing them down with ill-conceived regulations.

Betting is not fixing

You cannot hoard a commodity with a cash-settled swap. This is a terribly important thing to understand. A cash-settled swap can never result in anyone making or taking delivery of anything other than cash.

To explain this, I suggest the analogy of a racetrack. There are two distinct activities at the racetrack – the running of the race and the betting on its outcome.

Deliverable futures contracts are analogous to the running of the race. Something very real is happening that can be influenced by many factors – the health of the horse, the condition of the track, the weather, the skill of the jockey, the actions of anyone trying to fix the race, and so on.

A cash-settled swap is analogous to betting on the outcome of the race. Since the size of the bets does not affect the speed of the horses, there is nothing to be gained from implementing position limits on the bets.

If you want to ensure that the race is fair and you have a limited budget to police the track, it would seem prudent to dispatch the police to the paddock, the jockeys’ locker room, the stables and the track (the places where someone could unfairly influence the outcome of the race).

Do not send the police to the betting windows and do not make them arrest people for making bets that the police believe are excessive.

In the same way, our regulators should be dispatched to the markets that can be manipulated – the physical markets and physically delivered futures markets.

I am not against position limits where it makes sense to have position limits. I am against wasting time and money sending our commodity cops to places where crimes cannot be committed and I am against setting position limits for cash-settled swaps.

Analogies are useful but rarely perfect. When a contango is sufficiently steep in a storable commodity market, spot purchases may be made and stored for delivery against future speculative buying and this can have a subtle effect on cash and futures prices that is beyond the scope of this writing.

Notwithstanding this, no one has yet discovered any evidence that the activities of index funds or any other speculator has caused the recent volatility in energy prices.

Light in the shadows

On the issue of “dark markets”. That’s me. That is where I have been earning a living for the past 28 years.

Not all of us in this segment of the market are trying to keep the lights out. In fact, my company has invested many millions of dollars in the past few years illuminating the market landscape with electronic trading technology and straight-through processing. Our Amerex division licenses end of day market assessments (ie closing prices) for the natural gas basis and electrical power markets, which are used by over 100 of the largest participants in the North American wholesale energy markets.

We are certainly well known to our regulators, customers and the press. We are a member of the CFTC’s Energy Market Advisory Committee and the gas and power industry’s Committee of Chief Risk Officers, as well as the US Chamber of Commerce. We are comfortable with regulation and welcome its illuminating effect.

I do agree that commodities are different from equities. Everyone does not need to own equities but everyone does need to eat and shelter from the elements.

But banishing speculators from the markets is not the solution. It will only exacerbate the problem. Neither are price controls a sensible course of action (been there, done that). So long as our currency is debased by the borrowing of trillions of dollars, smart money will seek out hard investments, and none are harder than those that we cannot live without – water, food and energy.

The world economy is not in intensive care now because of a failure in the commodity markets. We are in this mess because as a country we overspent and undersaved for years. We bought houses that we could not afford with money borrowed from lenders who packaged our loans into derivatives that no one could understand (except the three rating agencies who told us that a whole bunch of these things were safe as mother’s milk) and sold them to buyers who had no idea what they were buying, often after they were insured by companies who had no idea what they were insuring.

The CFTC did not fail. The CFTC has, in my opinion, done a very good job with its limited resources. In particular, the former chairman, Walter Lukken, showed remarkable integrity and courage in continuing to hold to his convictions in the face of extreme political pressure to do otherwise.

I agree with the central premise of the FOW editorial. Denial will not do any of us any good. I know a lot of very smart, experienced people who are not speaking up. Those who can add to this discussion need to do it.

We need to create regulations that make for fair, efficient markets and we need to start by being honest about where we are and how we got here.

Postscript

I have now had the opportunity to meet with chairman Gensler and his staff. While I still have not seen any evidence that excessive speculation caused commodity price volatility and the extreme high prices of 2008, and I continue to disagree strongly with the CFTC’s apparent belief in the benefit of position limits on cash-settled swaps, I was impressed with the chairman’s grasp of current issues that I believe to be important. Most impressive to me was his apparently genuine desire to engage in dialogue to broaden and deepen his knowledge of the markets he is now charged with regulating. Perhaps I need to give the new sheriff and his gang the benefit of the doubt after all. n

Michael Cosgrove is head of commodities and energy brokerage for North America at GFI Group in New York.