Newsletter
8.24.2009
CFTC Considers Reining in Energy Speculators (or Manipulators)
How Does This Affect You?
Over the past month or so news has leaked out that several firms are being investigated for causing the run up in crude and natural gas prices last summer. In response to these investigations, the Commodities Futures Trading Commission (CFTC) is considering imposing restrictions on the number of positions speculators can take in commodities futures contracts. Already some of the firms with huge future contract holdings are strategizing how to get around the rules that have not yet been developed nor implemented. There’s a lot of money out there being made (and lost, but not by the same folks) by speculating in the futures markets and there are great minds at work trying to preserve these revenue streams. What value do speculators add? Do they have too much power? And knowing that they exist, what should end users of energy do to protect themselves?
A Bit of History
The way the story goes, the futures market in the US was developed to assist farmers by allowing them to sell forward their fall harvest, thereby giving them surety for the value of their future harvest and the finances to purchase seed for growing those crops. Taking the other side of these positions were industries that use farm products as inputs to their production, such as millers and possibly feedlots. This same business process has been used for many other industries, including the energy industry. Oil and gas firms can sell forward contracts, thereby locking in the value of future production. The issue today is that the futures contracts written exceed physical supply by many times over. Is the participation of speculators too much of a good thing?
Speculators have always been participants in these markets. Although they have no demonstrated need for the underlying commodity, they are active market players. Their business model is to buy futures contracts, but sell them before the contract comes due, thereby avoiding the inconvenience of taking delivery of the underlying commodity. Their hope would be that the commodity increases in value from the time they buy it to the time they sell it at some point in the future, thereby generating profits. They also can sell contracts, hoping the price will decline as the contract matures. Speculators add liquidity to the markets. The capital they add and the active trading they do allow for more efficient price discovery. As one could imagine, using the farmer example, once a farmer has the money to cover his spring planting he has little use for the futures market for the remainder of that year. Without enough buyers and sellers, severe market distortions would exist. The constant trading of speculators greases the machinery of financial markets.
Retail Energy Experience in Chicago
Retail open access for natural gas has been available in Illinois for about twenty years. Ever so many years, usually in October, we’d experience a sharp run-up in natural gas prices – more than market fundamentals would dictate – the hurricane season was over, there were no dire forecasts for an unusually cold winter and there was ample gas in storage. Whenever we inquired what was driving the market, the answer would be that the institutional investors were making a run at the market. At that time, the annual domestic gas market was about $50 billion and throwing a few billion dollars at it could move prices significantly. After a quick run up, prices would always settle back down again in a few months. In the meantime, the institutional investors would bail out (netting nice profits) leaving other late market entrants "holding the bag." This happened on more than one occasion.
Fast Forward to Last Summer
Last summer it appears that this process was overdone in both the gas and crude oil markets. Some very influential financial institutions were "predicting" that crude oil would hit $200/barrel before year’s end. The first explanation was that the increase in Chinese and Indian demand was the culprit for driving up oil prices. Some economist, analyzing data, debunked that theory. The next attempted explanation was the "Peak Production Theory" (which basically states you can’t get oil out of the ground fast enough to satisfy demand). Nope, this didn’t hold water either. While the theory may be true at some time in the future, it wasn’t applicable last year. Now there is a new theory – market manipulation. This theory seems to have more validity than the others and it seems to be sticking. Who doesn’t like to find fault with those who made vast sums of money while the rest of American society had to pay over four bucks for gasoline? This new theory seems to be moving toward inciting action. "Speculators" are worried because the next move is increased regulation.
The danger to all is when speculators aren’t really speculating because they know where the market is headed. They know because they are manipulating the market by moving it in a known direction. In most cases, whether it was the Hunt brothers manipulating silver back in ‘79/’80 or financial houses last summer, market forces eventually take over and the market clearing prices return. Unfortunately, no one knows how long it will take for the market recalibration to happen. In the meantime, how do end users who haven’t taken a future position for their energy needs respond?
A typical response starts with denial. This is most prevalent among those who know where the market is headed because they keep current with the energy markets through widely available periodicals. With lack of fundamental market support, the market movement doesn’t make sense – it is easy to deny something that doesn’t make sense. As the market continues to run up, denial transforms into fear – the "oh my gosh, I’m going to blow my budget" response takes over. At this point, fearing that things will only get worse, the energy/facility manager feels there is no way out of the current situation but to bite the bullet and lock in these higher prices. But there is still hope – prices could still go higher. While higher prices won’t help his budget at this point, they will help in explaining why he bought at a price above the price embedded in his annual budget figures. Timely reporting to management, illustrating how you avoided today’s high prices, is strongly recommended. This needs to be done before there is a correction and the bottom drops out of the market. While this behavior seems comical, the sad thing is that we see it all the time.
The reality is that we don’t know where market prices are headed. There are a select few that may "know," but that is because they are manipulating the market. No matter what restrictions are put on speculators, it won’t affect how you carry out your energy procurement process. Start with the basic assumption that you don’t know where prices are headed. With that as a basis, you can now develop a sound procurement policy that will allow you to take advantage of current low spot prices, but will insure against too high prices in the future as these markets recover. It takes good thought and consistent price monitoring. If you already have a good plan, review it. It won’t be wasted time. If you don’t have a plan, invest some time in developing an executable plan. It will make you look good.
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Update - ComEd Business Incentives
This past week we submitted the final application for a rebate from ComEd. We are happy to report that so far the process has been pretty easy and the personnel at ComEd have been most helpful. The incentive was about 20% of the total project cost.
We also inquired to see how much of the $16 million funds is still available. As of last week ComEd had received $11 million dollars worth of requests. That means that there is $5 million available for the asking. It seems that due to the slow economy end users are having trouble coming up with their share of the project costs. This unfortunate circumstance for some creates opportunity for those who have been slow to respond but still have funding available to take advantage of the incentives.