Do hedge funds have an impact on energy trading?
While the answer might seem intuitive, the debate as to whether they actually do has come to resemble the medieval theological dispute about how many angels can dance on the head of the pin.
Because, like angels, many trades in energy futures are invisible, and it is often not possible to pinpoint where they take place.
And yet, for most of us, including lawmakers on Capitol Hill, it seems obvious that when hedge funds buy and sell billions of dollars worth of oil and gas futures, it must be having an impact on energy prices. While hedge funds and other speculative traders would never dream of taking delivery of a barrel of oil, their trading activity affects the prices for actual consumers of oil and gas and their downstream customers or so it would seem.
When Gary Gensler, a former Goldman Sachs banker and Treasury Department official, was nominated last year as chairman of the Commodity Futures and Trading Commission the chief regulator for energy futures trading he reversed the CFTC party line that speculators don't have an impact on energy trading.
"I believe that excessive speculation in commodity futures can cause sudden or unreasonable fluctuations or unwarranted changes in commodity prices," Gensler said in a written response to lawmakers' questions ahead of his nomination hearing.
Gensler went on to pledge that if confirmed, he would have the CFTC guard against such speculation.
While he stopped short of saying that excessive speculation had taken place in the run-up of energy prices in 2008, he did express the opinion that the rapid growth of commodity index funds and increased hedge fund allocation to commodity assets contributed to the "bubble in commodities prices that peaked in mid-2008."
He noted that non-commercial investors sometimes account for up to 90% of open interest in a contract. (Open interest is a calculation of the number of active trades for a particular market, and is used as an indicator whether trading is becoming more or less active.)
Gensler's answer, enshrined in draft legislation currently before Congress, is to make trades more visible by requiring all over-the-counter derivatives to trade through an approved clearing house. While the thrust of new legislation is to get a better handle on financial derivatives such as credit default swaps, it will give regulators a better picture of all derivatives trading, including energy contracts.
At the same time, the CFTC and the Securities and Exchange Commission both are beefing up their ability to monitor hedge fund activity. The SEC for the first time will require hedge funds to register as investment advisors, and Gensler has pledged closer oversight of the funds that it supervises as commodity pool operators.
The industry, predictably, is pushing back. In congressional testimony on the new legislation, the Chicago Mercantile Exchange, the largest futures exchange in the world, and other exchange operators presented studies based on CFTC data to show that large positions held by index funds and other managed money were not "routinely detrimental" to the commodity markets in the period January 2005 to June 2008.
"All of the trader groups displayed instances of non-optimal behavior (including small traders), but none were consistently harmful to the studied markets," they said.
A task force of the International Organization of Securities Regulators (IOSCO) released a report last March that came to a similar conclusion.
"While reports reviewed by the task force concluded that fundamentals rather than speculative activity was the plausible explanation for price changes, the task force has made a number of recommendations to improve the transparency and supervision of these markets," IOSCO said.
These included suggestions regarding information about the underlying commodities, access to and sharing of information about trading positions, beefing up enforcement powers, and improving global coordination.
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