FIA president John Damgard’s letter campaigning against the Commodity Futures Trading Commission's proposed position limits on speculative energy trading contains the usual fallacies and fudges common to those who oppose controls on speculation.

1. The claim that “evidence” is needed before one can conclude that “speculation caused energy price distortions” is highly disingenous.

It is very difficult in any financial market, or economic situation of any kind, to prove precisely what caused what.

But what serious person would contend for a moment that speculation did not affect share prices? Or housing prices? Of course it does. Anyone who denied it would be laughed at as naive.

Yet Damgard would have us believe that commodity markets are somehow more virtuous and special than any other investable market in the entire world. Only here, he claims, does speculation not affect prices.

2. The claim that agricultural position limits have not made that market behave differently from energy markets undermines Damgard’s argument for no controls, rather than strengthening it.

If the behaviour of agricultural markets is not different from those of energy markets, it suggests either that the position limits do no harm (if you think the present operation of energy markets is unblemished, as Damgard does) or that stronger controls are needed (if you think energy markets have been distorted by excessive speculation).

3. The mantra that more speculation equals more liquidity equals tighter, more efficient markets does not stand up to scrutiny. (It is cheering that Lord Turner, chairman of the UK Financial Services Authority, has recently made this point.)

It is obvious that some speculative capital is needed in futures markets to oil the wheels between natural hedgers on the producer and consumer sides of the market.

It is equally clear that that speculative capital can overbalance the market. Damgard should look at the graph of the oil price over the past 30 years and then try saying with a straight face that “price discovery and efficient hedging” have become better in the last five years. During that time a huge influx of speculative capital has multiplied liquidity, as measured by futures trading volumes. Yet price swings have dwarfed those that occurred at any time in the turbulent 1970s, or any other decade.

At what point in 2008 did these highly efficient markets “discover” that the price of oil was too high – something that had been obvious to almost everyone else about a year before?

In reality, position limits on the activity of single players in the futures markets are unlikely to deal with the problem of excessive speculation. They may go some way towards preventing market manipulation such as cornering, but that has not apparently been a particular problem in recent years.

Even to prevent market manipulation in a concerted way, regulators would need to control a player’s aggregate position, across all media of trading – on and off-exchange derivatives and forwards and the physical spot market.

But the problem in recent years has not been market manipulation but herd behaviour by multiple players driving prices too far one way or another.

To prevent this, the only effective means would be an aggregate position limit that capped the total positions of all players deemed speculators.

For example, in energy, speculative players might be limited to 25% of open interest, leaving the rest to producers and consumers. There is likely to be no right answer to how high to set that cap. Regulators should raise and lower it depending on market conditions.

The point is not to punish speculators or drive them out of existence. If price behaviour is vaguely rational, they can be left alone.

But in the past few years in energy, price behaviour has been ludicrous. Commodities of exceptionally stable supply and demand have veered wildly in price.

The point of regulating trading activity is to see if these swings, which ultimately benefit only certain financial investors, can be curbed, by preventing large numbers of non-users of the commodity from exploiting its scarcity.

Unfortunately it has now become legitimate to “invest” in commodities, which means buying them in the hope that they will become more expensive. Surprise, surprise, the more people pile into that trade, the more likely it is to work. Tough luck for the rest of us, who have to eat and burn those commodities.

Jon Hay +44 207 779 8372 jhay@fow.com