Comment Text:
10-002
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HASISchool of Business ~,,~.¥.~
Gad.GARY
Philip K. Verleger
Telephone:
403,220,7971
Facsimile:
403,282,0095
phil[p.vorioger@hast~ayne,uCalgary.ca
April 23, 2010
David Stawick, Secretary
Commodity Futures Trading Commission
Three Lafayette Centre
1155 21
st
StNW
Washington, D.C. 20581
Re: Proposed Federal Speculative Position Limits for Referenced Energy Contracts
and Associated Regulations, 75 Fed. Reg. 4144 (Jan. 26, 2010)
Dear Mr. Stawick:
My name is Philip K. Verleger, Jr. I submit the attached comments on the CFTC pro-
posed regulations on position limits in certain energy futures as requested in the CFTC
notice published in the
Federal Register
on January 26, 2010.
I am the David Mitchell EnCana Professor of Global Strategy and International Manage-
ment at the Haskayne School of Business at the University of Calgary and president and
owner of PKVerleger LLC, a private consulting company that publishes reports on ener-
gy commodity markets. I am also a Senior Advisor to The Brattle Group, an internation-
ally recognized consulting firm.
I submit these comments as a private citizen and not on behalf of any interested party. I
also submit these comments as a student of energy commodity markets. I have been fol-
lowing the growth of these markets since 1982. Since that time, I have written two books
and many articles on their development.
My paper, "The Evolution of Oil as a Commodity" in Gordon et al. (1987) was the first
major academic paper to document the emergence of oil as a commodity and one of the
first to predict the consequences. I have tracked the development of oil and other energy
sources as they emerged from their cosseted, price-controlled, and integrated world to
become true commodities ever since.
1
Scurfield Hall ~ 2500 UniverSity Drive N.W,, Calgar),, Albert:a, Canada "[2N IN4 ~ www,haskayne,ucalgary.ca10-002
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Sincerely,
Philip K. Verleger
David Mitchell EnCana Professor
Haskayne School of Business
University of Calgary
2
SCurfield Hall ~ 2500University
Drivel,t.W,~
Calgary, AlberLa, Canada T2N IN4 ~ www.hasl~ayne,uCalgaryoca10-002
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Comments on Federal Speculative Position Limits for Referenced
Energy Contracts and Associated Regulations, 75 Fed. Reg. 4144 (Jan. 26, 2010)
1
Philip K. Verleger, Jr.
April 23, 2010
I submit these comments on the CFTC's proposed federal speculative position limits in
response to the Commission's request for comments as published in the
Federal Register
on January 26, 2010.
2
Here I will discuss the interaction of physical commodity markets with futures markets. I
will show that the growth of oil commodity markets has promoted the accumulation of
inventories and helped stabilize prices. I will also show that the success of these markets
has helped achieve a long-term goal of energy policy. Finally I will comment on the posi-
tive and negative impacts of the proposed regulations with regard to energy policy goals.
I. Conclusions
This analysis begins by noting that consuming countries have focused their energy poli-
cies for 30 years now on accumulating petroleum inventories. Governments of these ha-
~ I submit these comments as a professional economist and not on behalf of any interested party. I do not
trade any commodity futures contract now. I also have no financi!
!
interest in any party directly trading
commodity futures. I have received no financial support for this paper from any interested party. I have,
however, benefited from comments from several interested parties who have separately filed responses
with the Commission. Those comments have contributed to the clarity of this document, not its conclu-
sions.
2 See "Federal Speculative Position Limits for Referenced Energy Contracts and Associated Regulations,"
Federal Register
75, No. 16, January 26, 2010, pp. 4144-4172.10-002
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Verleger Comments on Federal Speculative Position Limits, page 2
tions have spent billions building strategic reserves that total more than 1.2 billion bar-
rels. The stocks have been built up in the belief, supported by economic theory, that high-
er inventories tend to dampen price fluctuations.
In recent years, passive investors such as pension funds have allocated a portion of their
assets to buying commodity futures to diversify portfolios. This diversification has had
the ancillary effect of promoting the accumulation of privately held oil inventories. The
rise in these stocks has tended to reduce price variations, as predicted by economic
theory. Thus the activities of passive investors have supported the goals of energy policy.
At the same time, the inventory accumulation stimulated by passive investment has not
affected oil prices because a cartel controls the level of global oil output. That organiza-
tion has boosted oil production to compensate for the oil going into stocks.
Under these circumstances, I conclude that imposing position limits as proposed by the
Commodity Futures Trading Commission would work against the goals of energy policy
and the objective of price stability. Inventories will decline if the regulations are adopted
as proposed and price volatility will increase. Consumers will pay higher prices. Firms
that use options to hedge (producers and consumers) will see costs rise as well.
The effect of the proposed CFTC rules on global inventories may be muted somewhat by
the fact that exchanges in Europe are not bound by them. Thus hedging activity and pas-
sive investment may move abroad. Oil stocks will follow. U.S. consumers might need to10-002
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Verleger Comments on Federal Speculative Position Limits, page 3
rely on inventories held thousands of miles away in the event of a demand surge. In fact,
this has already happened. On one occasion in 2005, the need to pull supply from such
distant supplies cost consumers more than $10 billion.
II. The Long-Term Goals of Energy Policy
Energy policy has been an important issue for overall economic policy for 37 years now.
Following the 1973 Arab oil embargo, the United States and other OECD members met
at the Washington Oil Summit in 1974. Willrich and Conant (1977) noted the resulting
agreement "in principal for an Integrated Energy Program (IEP) which combined provi-
sions to share oil supplies and restrain demand during supply emergencies with longer
range efforts to conserve energy and develop alternative energy sources" (p. 200). While
the phrase "price volatility" does not appear in their discussion, the steps taken at the
Summit were clearly focused on reducing it.
Since its inception in 1974, one of the key elements of the International Energy Agency
(IEA) has been the creation of government-controlled inventories, or strategic stocks. Be-
tween 1974 and 2010, IEA member countries have accumulated more than 1.2 billion
barrels of petroleum stocks that can be used to address market disruptions. The value of
these holdings exceeds $100 billion at current market prices. The U.S. government alone
has accumulated more than 700 million barrels of crude oil, which are held in salt domes
along the Gulf Coast.10-002
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Verleger Comments on
Federal Speculative
Position Limits, page 4
Strategic stocks have been sold into the oil market on several occasions over the last 20
years. They were first used in January 1991 as coalition forces attacked the Iraqi invaders
occupying Kuwait. Strategic stocks were also released in the fall of 2005 when the U.S.
petroleum industry was devastated by Hurricanes Katrina and Rita. On both occasions,
the release helped ease prices.
More generally, economists have often sought to moderate commodity price volatility.
Newbery and Stiglitz (1981) conducted a detailed examination of the potential for stabi-
lizing commodity prices. They concluded that price volatility has macroeconomic costs
and hence found that stable prices promote growth. They also found that providing im-
proved access to futures markets and expanding these markets both help achieve price
stabilization.
The research of Stiglitz and Newbery builds on the pioneering work of Keynes (1942),
who complained that raw materials prices tended to be very volatile, making it impossible
to manage production of these commodities. As Keynes noted,
The whole world is now conscious of the grave consequences of this de-
fect [price volatility] in the international competitive system. Apart from
the adverse effect on trade stability of the truly frightful
price
fluctuations
which we have learnet [sic] to accept as normal, they impose obstacles to
the holding of an adequate
quantity
of stock, the eventual effects of which
are not less injurious. For although the difficulty of rapidly altering the10-002
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Verleger Comments on Federal Speculative Position Limits, page 5
scale of output, especially of agricultural crops, leads to what appear to be
huge stocks at the bottom of the market, nevertheless, when the turn of the
tide comes, stocks turn out to be insufficient for the reason that it just as
difficult to rapidly increase the scale of delivered output as it had been to
diminish it. Prices rush up, uneconomic and excessive output is stimu-
lated, and the seeds are sown for a subsequent collapse (Keynes, 1942, pp.
113-114).
Keynes proposed a solution to this problem, suggesting that governments cooperate to
create commodity buffer stocks and manage global inventories of key commodities. Fol-
lowing the end of World War II, his proposals were tried for a number of commodities,
including coffee and rubber. International agreements were negotiated, buffer stocks ac-
cumulated, and production agreements established. In every case, the agreements even-
tually collapsed. However, the failure of these agreements has not prevented government
officials from pursuing price stabilization to this day.
Indeed, energy producers and consumers met at the end of March 2010 in Cancun to dis-
cuss the stabilization of energy prices. At the meeting, Lord Hunt, the UK's Minister of
State for Energy and Climate Change, summarized a commonly held view when he said,
"Oil price volatility has very negative consequences for the world as a whole. We need
stable and efficient energy markets. We need them both in terms of ensuring future in-10-002
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Verleger
Comments on Federal Speculative Position Limits, page
6
vestment and development but also need them in helping the globe as a whole recover
from the financial problems that we see in the last two years.
''3
Unfortunately, energy policy officials across the globe are uniformly uninformed of the
role played by commodity markets. Invariably, speculators and outside participants are
attacked for their activities when the evidence shows that these "outsiders" actually pro-
mote price stability. Apparently, almost all energy policy officials yearn for the days
when a few companies controlled oil supplies, refining, and distribution through a well-
run oligopoly. This system was best described by the various writers who attacked it in
the late 1960s and early 1970s. One academic, MIT's Morris Adelman (1972), docu-
mented the oligopoly's operation in detail.
III. The Role of Futures Markets
Today's energy market is well understood by those versed in agricultural economics but
clearly not comprehended by those making energy policy in most international institu-
tions.
4
Stated simply, futures markets allow traders to move commodities from one period
to a future period. This is accomplished by buying a "lot" of the physical commodity,
storing it, and selling a futures contract against the stored lot. The process is called hedg-
ing.
~ "UK Backs IEF [International Energy Forum] Charter; Sees Benefit for World Economy: Minister,"
Platts Online,
March 31, 2010.
4 The U.S. Department of Energy has been an exception. At the recent IEF meeting in Cancun, the United
States' representative said that energy prices should be set by supply and demand. This view differed from
those expressed by apparently every other person who attended the meetings.10-002
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Verleger Comments on Federal Speculative Position Limits, page 7
Working (1962) did a thorough analysis of the explanations for such economic behavior.
Williams (1986) updated this exploration of why economic agents might hold invento-
ries.
Research by Working (1949) and Brennan (1958) demonstrated empirically that a nonli-
near relationship, called the supply of storage, exists between commodity inventories
held by economic agents and price spreads. In this relationship, inventories tend to rise as
the fol"vvard price increases relative to the cash price. Williams (1986) offered an abstract
illustration of this correlation, shown here as Figure 1.
The supply-of-storage concept described by Working and Brennan fits within an econom-
theory of arbitrage. Under the theory, the profit earned by purchasing a physical com-
modity, storing it, and selling a future against it increases as the futures price rises rela-
tive to the cash price.
The return to storage
also rises as the cost
of holding stocks
declines and/or as
the cost of financing
the inventory de-
creases. Williams
(2001) reported that
Figure 1
Theoretical Supply-of-Storage Curve
--
Relationship between Inventories and Price Spreads
Spread (S/unit)
10 ,
(lo)
(20)
(30),
(40) ~
(5o)
-~
....
,
o
20
40
60
80
Inventories
100
120
Source:
Jeffrey C. Williams,
The Economic
Function of
Futures Markets
(Cambrfdge, England:
Cambridge University Press,
1986).
14010-002
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Verleger
Comments on
Federal Speculative
Position Limits,
page 8
a nonlinear negative relationship was found for every commodity studied (p. 763) and
then explained that "commercial firms, nationwide or worldwide, look to the spreads in
the principal futures market as the guide to their inventory decisions" (p. 764).
This view of the role of futures markets has been largely ignored in the financial litera-
ture. Instead, futures contracts have been viewed as a financial instrument similar to equi-
ty or debt instruments. Recent literature on futures markets for physical commodities al-
most totally skips over the potential profitability of hedging. Yet reports in the daily fi-
nancial press document many instances where firms have earned very large returns by
purchasing physical commodities, selling futures, and holding the commodity for deli-
very.
s
Empirical economic research--as well as the academic work of Working, Williams, and
Brennan--documents the linkage between conditions on futures markets and inventory
levels. Inventories build as the forward price rises relative to the cash price (described as
increasing contango). Inventories fall when the price offered for supplies delivered in the
future declines relative to the cash price. (The term "in backwardation" is used to de-
scribe a market where futures prices are less than cash prices.)
5 Perhaps the most visible story concerns U.S. bank JPMorgan. On June 3, 2009, Bloomberg reported that
JPMorgan Chase had hired a newly built supertanker to store heating oil off Malta. The ship could hold
about 273,000 tons. Bloomberg calculated that JPMorgan Chase paid 3.85 to 4.5 percent to store the oil
fi'om June to August 2009. Bloomberg also calculated that JPMorgan Chase paid $553 per ton to buy heat-
ing oil in Europe and could have sold the oil for delivery in August for $580 per ton. Deducting storage
costs, JPMorgan's profit was probably around $20 per ton if the oil was sold for delivery in August. The
return on the investment for the three-month period would have been well in excess of 100 percent at an-
nual rates if JPMorgan Chase financed 90 percent of the cost through the Federal Reserve. See Alaric
Nightingale, "JPMorgan Hires Supertanker for Storage, Brokers Say," Bloomberg, June 3, 2009, for details
on the transaction.10-002
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Verleger Comments on Federal Speculative Position Limits, page 9
IV. The Bilateral Nature of Futures Contracts
The word "bilateral" rarely appears in papers or books on futures markets. Yet the fun-
damental foundation of a futures market is the two-sided nature of contracts. For every
buyer, there must be a seller. This fact distinguishes futures markets from equity markets.
Futures contracts also carry an obligation. Most energy futures contracts obligate the con-
tract buyer to take delivery of a specified amount of the commodity when the contract
expires unless the buyer "offsets" its position by selling the futures contract before the
expiration date. Most energy futures contracts obligate the contract seller to deliver a spe-
cified amount of the commodity when the contract expires unless the seller "offsets" its
position by purchasing a contract.
6
In equity markets, a firm's board of directors determines the number of its shares out-
standing. The board of Google®, for example, and only the board of Google decides how
many shares of Google are available to the market at any time. This can change as hold-
ers of restricted stock grants are allowed to sell shares. However, the timing of the sale is
set by the grant offered by the board.
In contrast, the number of contracts outstanding in a commodity is determined by the
number of agents willing to sell the commodity at any one time and the number of agents
6 Some contracts are settled by cash payments. "Cash-settled contracts" require the buyer to pay the seller
an amount determined in the physical market at the end of trading on the day the contract expires rather
than the buyer taking delivery. In practice, most futures contracts are settled by offset rather than delivery.10-002
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Verleger Comments on Federal Speculative Position Limits, page 10
willing to buy contracts. An increased interest in buying futures will only lead to an in-
creased number of contracts outstanding if the buying interest is matched by an increased
willingness to sell.
For example, at the end of March 2010, there were approximately 41,000 contracts out-
standing on feeder cattle. There would be no increase in the number of contracts out-
standing tomorrow were buyers to suddenly offer to purchase another 100,000 contracts
unless sellers of a like number of contracts could be found. No doubt, some sellers would
appear as prices were bid higher. However, it is not clear whether enough sellers would
step up to meet the demand for the additional 100,000 contracts or if the buyers would be
willing to pay the higher price required to realize the purchase.
This point is often overlooked. Below, I note that those who advocate using commodities
as an alternative investment have failed to understand that increased demand for futures
contracts from such investors must change price relationships. Again and again, econo-
mists seem to ignore the fact that forward prices will rise relative to cash prices if a large
number of buyers of forward contracts enter the market.
The bilateral nature of futures contracts also extends to options on futures contracts. Op-
tions give the buyer the right to be long or short a futures contract but not the obligation.
For example, an airline can purchase calls on heating oil with a strike price of $2 per gal-
lon for November 2010 delivery, assuming of course that some other party is willing to10-002
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Verleger Comments on Federal Speculative Position Limits, page
11
sell calls to the airline.
7
If heating oil rises above $2 per gallon, the airline can demand
that the seller hand over a futures contract for November 2010 with a purchase price of
$2 per gallon. The airline can then take delivery of heating oil for that price. However, in
practice, the airline would take the profit (the difference between the market price and the
$2 per gallon), while offsetting the contract. If prices fell below $2 per gallon, the airline
would allow the option to expire.
Producers will purchase puts to protect against a fall in prices. For example, a producer
could buy puts on crude oil for delivery in March 2011 with strike prices of $80 per bar-
rel. If prices fell below $80, the producer could demand that the seller transfer futures
contracts based on the $80 price into their accounts.
The bilateral parties in options trading will buy futures if they write calls or sell futures if
they write puts. The number of contracts bought or sold relative to the number of options
written will be determined by the difference between the market price and the strike price
(price spread), the number of weeks or months until the option expires (duration), and the
expected price variance (called the "implied volatility"). The finance literature is replete
with books and articles purporting to show the variation in how many futures should be
bought or sold to cover a specific options position given the price spread, duration, and
implied volatility in the market.
7 Heating oil is the petroleum product traded on futures markets most similar to jet fuel. Airlines can also
purchase over-the-counter options on jet fuel. The financial institutions writing such options frequently
hedge their obligation with heating oil futures.10-002
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Verleger Comments on Federal Speculative Position Limits, page
12
V. The Linkage between Inventories and Price Spreads in Energy Markets
Research by Working (1949), Brennan (1958), and Williams (1986) has quantified the
linkage between inventory levels and price spreads. As noted above, the relationship is
nonlinear. When inventories are high relative to demand, forward prices tend to trade at a
premium relative to cash prices, a condition called contango. Furthermore, under the non-
linear relationship, large changes in inventories tend to lead to small price changes.
In contrast, this well-understood research shows that cash prices tend to trade at a pre-
mium when inventories are below normal levels, a condition called backwardation. The
nonlinear relationship also dictates that small changes in inventories lead to large changes
in spot prices when stocks are low.
Location also matters, although there is as yet little published academic research on the
subject. At least in the case of energy commodities, the linkage between inventories and
price spreads is better when one examines the limited amounts of energy held in the deli-
very market rather than the national or global inventory levels. The increase in correlation
is explained here by the increased ease of delivery. Firms seem more willing to accumu-
late inventories if they can be hedged at a nearby delivery location.10-002
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Verleger Comments on Federal Speculative Position Limits, page 13
The nonlinear relationships postulated by Working, Brennan, and Williams are observed
in the oil market. Figures 2 through 4 provide clear illustrations of the effect. Figure 2
focuses on crude. The graph shows the inventory/price spread relationship observed for
privately held U.S. crude inventories in Cushing, Oklahoma.
Cushing is the delivery location for crude oil under the NYMEX futures contract. Firms
holding a long posi-
tion and going to de-
livery must take de-
livery of the oil in
Cushing unless an
alternative delivery
location can be nego-
tiated in the few days,
after futures trading
ends. Firms that are
Figure
2
Privately
Held U.S,
Crude Oil Inventories in Cushing
(OK)
vs. Price Spread, t990-2010
Price Spread (Third Future
less
Cash; $/bbl)
12
[]
10
[]
8
[]
6
[]
[]
[]
[]
[]
2
[]
0
(2)
~
[]
(4)
~,
,
~
10
15
20
25
30
Cushing Crude Stocks (Million Barrels)
Source: PKVedeger
LLC.
40
short futures con-
tracts must make delivery in Cushing unless they can negotiate an alternative delivery in
the first days after the contract expires.
A similar relationship exists for heating oil. Figure 3 (page 14) compares heating oil in-
ventories held in the delivery market (technically referred to as PADD I or Petroleum10-002
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Verleger Comments on Federal Speculative Position Limits, page 14
Administration for
Defense District I)
with price spreads.
These inventories are
held in East Coast
facilities near the
delivery location.
For heating oil, we
show observations
Figure 3
U.S. PADD I Heating Oil Inventories vs.
Last Week of January Price Spread, 1990=2010
Price Spread (Third Future
less
Cash: cents/gal)
0.20 -
0.10
0.00
(0.10)
(o.2o)
(0.30) ........
(0.40)
(0.50) -
,,
(o,6o)
30
Source: pKVorleger LLC.
40
50
60
PADD I Heating Oil Stocks (Million Barrels)
70
for the last week of January from 1990 through 2010. Data are presented in this manner
because with heating oil, there is a significant fluctuation in stocks over the course of a
year. Again one observes that Working's conjecture is validated.
This last conclusion
is reinforced by Fig-
ure 4. Figure 4 com-
pares U.S. crude oil
inventories with
crude oil price
spreads from 2000 to
2010. The price
Figure 4
U.S. Privately Held Crude Stocks vs. Crude Price Spread,
Monthly Data, 2000-2010
SNcks(Miiiion Barrels)
Price Spread(Third Futureless Cash;$/bbl)
380 ,
-10
Stocks
360-I
F~3
340-t
5
320
t
300-1
0
280
260
=-5
2000
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Sours: CFTC; U.8. DOE.
~10-002
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Verleger Comments on Federal Speculative Position Limits,
page 15
spread (third future less cash) is graphed against the right vertical axis and is shown as
vertical bars while the level of privately held crude oil inventories is graphed against the
left vertical axis and shown as a line. The graph demonstrates that inventories tend to be
higher when price spreads are positive than when spreads are negative.
VI. Oil Commodity Markets: A Persistent Lack of Longs
The bilateral nature of commodity markets requires that every short position be matched
by a long position. Historically, there have been a plethora of"shorts." Unfortunately,
longs have not been as plentiful. The absence of longs has tended to push markets into
backwardation and discourage innovatory accumulation.
Gasoline provides an ideal example of the problem. In theory, there should be a group of
consumers willing to purchase volumes of fixed-price gasoline. Clearly, astute consumers
could be convinced to buy gasoline in advance because they no doubt lcnow of the histor-
ical tendency of gasoline prices to rise in summer as driving increases. After all, many
heating oil and natural gas consumers have been willing to "lock in" winter heating fuel
prices in the fall. A similar strategy would make sense for gasoline.
However, a large number of impediments prevent consumers from adopting this ap-
proach. First, most consumers patronize more than one gasoline station. In fact, they most
likely stop at whatever station is convenient when their vehicle's tank nears empty. As
Theodore Levitt (1960) noted in his seminal paper "Marketing Myopia,"10-002
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Verleger Comments on Federal Speculative Position Limits, page 16
It can be shown that motorists strongly dislike the bother, delay and ex-
pense of buying gasoline. People actually do not buy gasoline. They can-
not taste it, feel it, appreciate it, or really test it. What they buy is the right
to continue driving their car. The gas station is like a tax collector to
whom people are compelled to pay a periodic toll as the price of using
their car.
8
Consumers may join golf clubs, yacht clubs, or churches, but few show much affinity for
gasoline suppliers unless the supplier offers something of value, such as a discount. Re-
cently, Wal-Mart and Costco have gained market share here. Other integrated companies
have also won customer loyalty by offering credit or debit cards tied to MasterCard or
Visa.
The integrated oil companies cannot offer fixed prices to their customers through their
dealer networks because dealers are independent businessmen. Federal and state statutes
prohibit the integrated firms from setting retail prices charged by distributors. A specific
law, the Petroleum Marketing Practices Act, passed following the 1973 Arab oil embar-
go, makes it impossible for a multinational oil company (ExxonMobil, for example) to
require a distributor marketing its gasoline to honor a fixed-price contract between the
company and the customer.
8 Theodore Levitt, "Marketing Myopia,"
HarvardBz¢siness Revimv
(July-August 1960) (reprinted in HBR
Reprint 75507, September-October 1975), p. 9.10-002
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Verleger Comments on Federal Speculative Position Limits, page 17
Gasoline hedging is further complicated by differences in state motor fuel taxes. The gas-
oline tax in Georgia is 7.5 cents per gallon, while the Rhode Island tax is 32 cents per gal-
lon. Since gasoline margins are often less than ten cents per gallon, a firm that sold fixed-
price gasoline in Georgia would face financial ruin if its customers purchased fuel in
Rhode Island.
These complications have made it impossible to market fixed-priced gasoline to consum-
ers. As a result, the market has historically been short of"longs."
Distillate markets offer a sharp contrast. Heating oil consumers have been large users of
fixed-price contracts. Airlines have also been large forward buyers of fixed-price jet fuel,
the price of which is linked to heating oil. Trucking companies have also been able to en-
ter into fixed-price contracts for diesel fuel with the two or three major marketers.
9
One can measure the relative importance of the futures markets by comparing the ratio of
open interest in a futures contract to consumption. The higher the ratio, the greater the
potential is for hedging. Figure 5 (page 18) shows futures coverage relative to consump-
tion. On this graph, I show the number of contracts outstanding at a moment in time di-
vided by the Department of Energy's estimate of consumption at that point. For example,
in January 2000, there were 11 futures contracts outstanding for each barrel of gasoline
consumed daily. On the same date, there were 44 futures contracts outstanding for each
9 In the United States, three firms, Flying J, Loves, and Pilot provide much of the over-road fuel consumed
by trucking companies. These three firms own their own stations, thereby avoiding the problems associated
with the Petroleum Marketing Practices Act. Furthermore, their customers are sophisticated enough to un-
derstand and accept differences in prices by region.10-002
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Verleger Comments on Federal Speculative Position Limits, page 18
barrel of daily heat-
ing oil consumption.
Ten years later, there
were 36 futures con-
tracts per barrel of
daily gasoline con-
sumption outstand-
ing but 86 contracts
of heating oil futures
contracts per barrel
of daily consumption.
Figure 5
Gasoline and Distillate Futures Contracts Outstanding
per Barrel of Daily Consum ption*
Contracts Outstanding per Barrel of Daily
Consumption
10(~ ~
Gasol[ne Distillate
90 ~1 ~
~
8O
70
80
20
H
2000
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
*Ratio of open interest in gasoline and distillate futures divided by comtemporaneous
U.S. consumptlotl,
Source'. PKVedeger LLC,
These coverage ratios are important to many firms that seek to produce and market gaso-
line or heating oil. Over the last 20 years, the U.S. Federal Trade Commission has ag-
gressively worked to promote competition in the refining business by requiring that large
integrated companies shed refineries as a condition for mergers. Many refineries once
owned by integrated companies such as BP, Chevron, Conoco, ExxonMobil, and Shell
have been sold to firms such as Frontier, Tesoro, or Valero. The companies selling the
refineries have historically been able to buffer profits or losses in refining with profits
from crude production. The buying firms have no such protection.
The ability to profitably hedge inventories provides financial protection that allows inde-
pendent refiners to accumulate stocks. The inability to profitably hedge inventories forces10-002
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firms to hold fewer stocks. Hence, the creation of buyers of futures to take the other side
of the hedged sale is very important. The lack of longs discourages inventory accumula-
tion.
VII. Passive Investors: Taking the Role of the Missing Long
Investment banks began to tout commodities as an alternative investment instrument to
clients as early as 1990. In 1994, Goldman Sachs published a detailed report on the sub-
ject that contained a paper by Kenneth Froot, then a professor of finance at MIT's Sloan
School. The Froot paper was later published (1995) in
The Journal of Portfolio Manage-
ment.
Froot suggested that returns earned from a diversified portfolio of commodities would be
negatively correlated with returns earned on equities and returns earned on fixed-income
assets such as bonds. These findings led him to suggest that investors should consider
putting money in commodities to diversify portfolios. In the accompanying Goldman
Sachs publication, another economist showed that investors could achieve this diversifi-
cation by pursuing commodity futures contracts that would expire in a relatively short
time, holding the futures until the expiration date approached, then selling the futures
contract, and buying the next expiring contract.
Goldman Sachs introduced the Goldman Sachs Commodity Index (GSCI) in 1991, a di-
versified portfolio of commodities. Goldman provided a formula (a set of weights) that, if
followed by investment managers, would allow investors to construct a diversified port-10-002
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Verleger
Comments on Federal Speculative Position Limits,
page 20
folio of commodity futures that Goldman claimed mirrored the importance of the com-
modities in the economy.
In 1994, JPMorgan followed Goldman Sachs with a second index. The JPMorgan index
was designed to achieve the same effects.
The Goldman and Morgan indices had a second purpose: attracting buyers for the futures
sold by producers to hedge positions. In theory, the addition of new longs to the market
effectively allowed producers and processors to hedge additional volumes without push-
ing the market into backwardation.
However, passive investment in commodities did not gain popularity immediately, as can
be seen from Figure 6, which traces the notional amount invested in commodities from
1990 to 2009. This
chart shows that sig-
nificant volumes
were not invested in
commodities for at
least 12 years after
the concept was in-
troduced.
Figure 6
Amounts Invested in GSCI and DJ-UBS Commodity Indices
Billion
200
150
100
5O
Dollars
N DJ-UBS [] GSC~
Source:
PKVerleger LLO,10-002
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Verleger Comments on Federal Speculative Position Limits, page 21
The failure of investment managers to quickly adopt commodities as an asset class can be
explained by a single phrase: career risk. A 1995
Wall Street Journal
article chronicled
the difficulties confronted by those who favored commodities as an asset class:
Ill-fated adventures in derivatives trading in the past year have further
dampened enthusiasm for Wall Street's brave new commodity products,
pension managers and consultants agree. "It's called career risk," the risk
that new-fangled investments will backfire and the manager get the boot,
said one fund manager, who asked not to be named.
1°
The author added that one retirement program had already backed away from investing in
commodities. Others were very reluctant to proceed despite the assurances of the large
investment banks.
A review of Figure 6 suggests that passive investment became popular in 2004. The year
corresponds to the circulation of the first papers on commodity investment by Gary Gor-
ton of Yale and Geert Rouwenhorst of the University of Pennsylvania. The research pub-
lished by these academics showed that a properly constructed portfolio of commodities
was negatively correlated with returns on equities and returns on bonds. This finding led
the authors to argue, like Professor Froot, that investors could achieve portfolio diversifi-
cation by investing in commodities.
s0 Suzanne McGee, "Respectability Remains Elusive Despite Boom in Prices,"
The Wall SO'eet Joztrnal,
May 8, 1995.10-002
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Verleger Comments on Federal Speculative Position Limits, page 22
Gorton and Rouwenhorst (2004, 2006) provided a very detailed explanation of how in-
vestors could earn returns on commodities. They began by noting that the expected return
did not come from appreciation. To the contrary, they asserted that investors could earn a
positive return from the "risk premium" normally associated with commodity markets.
Investment in commodities would normally earn a positive return as long as the futures
price is set "below the expected future price" (2004, p. 4).
The authors added that investors in commodities normally earned a risk premium. This
risk premium is tied to
normal backwardation,
a concept introduced by Keynes. They
stated that, under Keynes' theory, "the risk premium, on average, will usually accrue to
the buyer." Gorton and Rouwenhorst noted that Keynes "envisioned a world in which
producers of commodities seek to hedge a portion of their output." The authors then ex-
plained,
Speculators provide this insurance and buy futures, but they demand a
price that is below the spot price that is expected to prevail at the maturity
of the futures price. By "backwardating" the futures price relative to the
expected future spot price, the speculators receive a risk premium from
producers for assuming the risk of future price fluctuations (2004, p. 4).
Gorton and Rouwenhorst were not the first to advance the normal backwardation hypo-
thesis. Froot (1994) and Walton (1991) both offered the same theory 15 years earlier. The10-002
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Verleger Comments on Federal Speculative Position Limits, page 23
repetition of the theory, however, seems to have convinced investors that backwardation
is indeed the normal condition for commodity markets. This happened despite the fact
that Williams (1986) had dashed the theory earlier. In a review article published in 2001,
he wrote, "If any consensus has emerged [from the literature], it is that no significant
downward bias exists in futures prices. By implication, speculators are not attracted to
futures markets to earn a risk premium through a naive trading strategy." (2001, p. 771).
Williams' work was ignored, though, in part because it was written for those who study
physical commodity markets, particularly agriculture markets. Those practicing in
finance either did not recognize there was serious research that cast doubt on the com-
modity investment theory or chose to ignore the findings.
Consequently, investors, also unaware of Williams' research, poured cash into commodi-
ty futures. Figure 6 above shows that investment rose quickly over the last decade. The
cash influx was balanced by a shift in the market from backwardation to contango, which
can be seen in Figure 7 (page 24). This graph shows the spread between the WTI fourth
futures price and the WTI cash price. Negative numbers denote backwardation and posi-
tive numbers contango. One can observe that the market oscillated between backwarda-
tion and contango until the end of 2004. Then from the beginning of 2005 until August
2007 and then again from June 2008 to the present, the market has been in strong contan-
go. As noted, the cdntango period is associated with the flow of cash into commodities
from passive investors. Their buying caused open interest in crude and other futures to10-002
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Verleger Comments on Federal Speculative Position Limits, page 24
rise sharply, as can
be seen from Fig-
ure 8. This increase
also contributed to
the market's shift
from backwardation
to contango.
The shift to contango
Figure 7
Price Spread between Fourth Light Sweet Crude Contract
and Cash WTI, Weekly Data, 1986.20'10
Dollars per Barrel
15
10
5
0
(5)
(lO)
occurred because
those buying futures
(passive investors)
needed someone to
buy from. Sellers
were attracted only
when the buyers of-
fered the sellers a
premium to continue
Figure 8
Open Interest in Three Principal Crude Contracts vs,
Fourth Crude Price Spread, 2000-2010
Price
Spread (Fourth Future
less
Cash; $/bbl)
15
Open Interest
10
5
0
Open Interest (1,000 Contracts)
3000
2500
2000
1500
1000
(5) 5o0
2000
2001 2002 2003 2004 2005 2006 2007 2008 200'9 2010
Source:
PKVerleger LLC,
~
storing their oil or
parcels of other commodities rather than selling on the cash market.
This promoted inven-
tory
accumulation.10-002
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Verlcger Comments on Federal Speculative Position Limits, page 25
Williams and Wright (1991) described the effect of passive investors in their book
Sto-
rage and Commodity Markets.
The authors built a multi-period dynamic model in which
economic agents that produce output in Period 1 and intend to produce output in future
periods must choose between selling the output produced in Period 1 and putting it in sto-
rage to hold for delivery in Period 2 or in some later period. The decision to store or sell
depends fundamentally on whether the futures price offered for delivery in Period 2 (P2)
exceeds the price offered in Period 1 (P1) by an amount sufficient to cover storage costs
plus insurance costs plus the loss from Period 1 to Period 2 (C). Thus, the storage rule is
written this way:
Store if P2
> P1 +
C
Passive investors inadvertently triggered this rule as they purchased futures. Their buying
lifted the forward price relative to cash prices, promoting inventory accumulation.
Williams and Wright also explained that market equilibrium occurs when the cash price
rises relative to the forward price. As they observed, cash prices (prices in Period 1) will
rise relative to forward prices as supply is diverted from the market and stored. This
process leads to intertemporal equilibrium under certain stringent assumptions.
The Williams and Wright research could lead one to conclude that futures buying by pas-
sive investors tends to lift cash prices as economic agents are prompted to store physical10-002
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Verleger Comments on Federal Speculative Position Limits, page 26
commodities rather than market them, which reduces contemporaneous supply and drives
prices up.
Such conclusions may apply to some non-energy commodities such as grains or metals. It
does not, however, apply to oil markets or, at least at present, to natural gas markets.
Cash prices do not rise as storage increases because the world crude oil market is not
competitive, a key condition for the Williams and Wright finding to hold. (The result
does not apply to U.S. natural gas markets today because natural gas storage capacity is
insufficient, as we explain below.)
In the case of crude oil, the spot price is generally determined by the amount of oil the
Organization of Petroleum Exporting Countries (OPEC) chooses to produce. Commenta-
tors who attend the periodic OPEC meetings report that the organization's decision to
increase or decrease output is influenced by the cash price. While the organization has
not by any means succeeded in establishing a perfect record regarding stabilizing crude
prices, the fact that its actions are determined by cash or spot prices neutralizes the possi-
bility of passive investor activity sending cash prices higher.
11
The situation in natural gas is different. Natural gas production in the United States is
highly competitive. The growth in output from shale gas has caused a significant decline
11 Cash prices can be driven higher by other factors such as environmental regulations. For example, the
rise of crude prices to $150 per barrel was caused by environmental regulations imposed by the European
Union (see Verleger, 2009). These rules created a situation where refiners were unable to process available
volumes of heavy, high-sulfur crude into the product required at the time, ultra-low-sulfur diesel fuel. As a
consequence, the world experienced the anomalous situation of having a crude surplus in the Middle East
and yet very high crude prices.10-002
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Verleger Comments on Federal Speculative Position Limits, page
27
in cash prices. Under these conditions, forward buying by passive investors could cause
producers to put gas into storage, removing supplies from the cash market and sending
spot prices higher
~there were sufficient storage capacity.
The evidence suggests there is
not. Strong anecdotal evidence from 2009 points to storage facilities being full, forcing
many producers to choose between accepting very low prices and reducing output.
Evidence from current market behavior, then, leads me to conclude that the entry of pas-
sive investors has promoted inventory accumulation without causing cash prices to rise.
As I noted in Section II above, this has been
the
primary goal of energy policymakers for
decades.
VIII. Evidence of Linkage between Passive Investor Activity and
Inventory Accumulations
Economists are often correctly criticized for offering brilliant theories that fail under em-
pirical examination. Here I have argued that investments by passive investors have pro-
moted inventory accumulation. This hypothesis is confirmed by the facts.
Figure 9 (page 28) shows U.S. PADD I heating oil inventories from January 2000
through the end of March 2010. The Department of Energy reports these data weekly.
Also shown in Figure 9 are data on open interest in heating oil futures. Due to differences
in units, data on open interest are graphed against the right vertical axis and inventory
data against the left vertical axis. The graph suggests a clear relationship. Note in particu-10-002
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Verleger Comments on Federal
Speculative Position Limits,
page 28
lar that the surge in
open interest from
June 2008 through
March 2010 was
matched by an equal
increase in stocks.
This point is empha-
sized in Figure 10,
which compares
weekly stock levels
from January 2000 to
March 2010, graphed
against the vertical
axis, with open in-
terest, graphed
against the horizon-
tal axis. The linkage
between open inter-
est and inventories is clear.
Figure 9
PADD I Heating Oil Inventories vs. Open Interest in
Heating Oil, Weekly Data, January 2000 to March 2010
Stocks (Million Barrels)
Open Interest (Thousand Contracts)
80 ,
!nventories Open
Interest
70 ~1
40
20 I
2000 2001 2002 2003 2004 2005 2006 2007 2008
8ource~ PKVedeger LLC.
- 350
- 300
- 250
-200
-150
-100
5O
2009 2010
Figure 10
PADD I Heating Oil Inventories vs. Open Interest in
Heating Oil, Weekly Data, January 2000 to March 2010
Stocks (Million Barrels)
160
180
200
220
240
260
280
300
320
340
Open Interest (Thousand Contracts)
Source: PKVedeger LLO.
~,~"
The conclusion here is that the flow of cash into futures from passive investors has con-
tributed to a rise in heating oil inventories. This suggests that the activities of passive in-10-002
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Verleger Comments on Federal Speculative Position Limits, page
29
vestors have indirectly promoted stock accumulation by shifting energy markets from
backwardation to contango. In the process, these investors have become a force for price
stabilization, no doubt causing returns on investment to decline or even become negative.
This was not the goal of passive investors nor is it the effect for which they have been
criticized.
IX. How the Winter 2009/10 Market Benefited from the Stabilizing Influence of In-
vestors
The regions north of the equator experienced one of the longest and most extreme epi-
sodes of cold weather in 50 years during the winter of 2009 and 2010. in Europe, the Eu-
rostar trains running from London to France, one of the world's recent technological mi-
racles, were stopped by cold weather and by snow accumulating on electrical contacts.
Workers in Frankfurt and Stockholm were told to stay home for three or four days. In
China, the government ordered natural gas supplies diverted from industry and govern-
ment buildings to residences. In the United States, many states on the East Coast expe-
rienced extreme cold.
In the past, such an episode would have been accompanied by a sharp rise in heating fuel
prices. However, there was no increase of this type in 2009/2010. Prices remained stable
in December 2009 and January 2010 for two reasons: energy commodity markets have
finally matured and financial institutions have encouraged a large number of passive in-
vestors to allocate a portion of portfolios to commodities. Credit for the absence of a
price surge should go to financial engineers and financial institutions that had the fore-10-002
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Verlegcr Comments on Federal Speculative Position Limits, page
30
sight to integrate energy markets and investors. This is an area of activity that offers ma-
jor consumer benefits. As Wall Street continues to undergo a storm of criticism, the insti-
tutions and individuals there who helped create this innovation deserve kudos for the
achievement, as well as the gratitude of consumers.
The December 2009/January 2010 success occurred because the world entered winter
with extraordinarily high levels of heating oil and natural gas inventories. As economists
have long acknowledged, plentiful stocks provide a natural buffer to unexpected increas-
es in commodity demand. This winter, global heating oil stocks were 20 to 30 percent
above levels observed in prior years. Natural gas inventories were also much higher.
The "extra" stocks were sold to meet the unanticipated demand created by the cold
weather. Thus, in the U.S., spot heating oil prices barely budged. In contrast, spot prices
jumped almost 70 percent during frigid weather in January 2000. That price increase was
attributed to low stocks in subsequent analyses done by the U.S. Department of Energy.
DOE also blamed low inventories for the 50-percent price increase during a December
1989 cold snap.
Market forces, not government intervention, created the abundant inventories that buf-
fered markets in 2009 and 2010. Energy futures contract purchases lifted futures prices of
commodities such as oil relative to current or cash prices. Commercial players in the
markets responded to the rise in futures prices by buying and storing physical volumes of
commodities such as natural gas and oil, while selling futures contracts to the investors.10-002
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Verleger Comments on Federal Speculative Position Limits, page 31
World inventory levels rose through these serendipitous interactions, not because some
government official commanded companies to add oil to stocks.
JPMorgan was one of the firms that bolstered inventories. As noted earlier, Bloomberg
reported that the company hired a brand new supertanker last June to store two million
barrels of heating oil. According to the article, the firm could buy the oil for $553 per ton
and sell it for delivery three months hence for $580. This transaction may actually have
occurred a few weeks earlier and if so, the bank could have acquired the oil for $400 per
ton and sold it for delivery in January 2010 for $500.
The "cash-and-carry" transaction credited to JPMorgan is a well-loaown practice. Agri-
cultural firms have engaged in such activity for more than 100 years. In 2009, JPMorgan
and many other firms acquired oil in this manner, often earning risk-free returns exceed-
ing 50 percent.
Consumers across the globe benefitted from this entrepreneurialism because prices did
not rise when the weather turned cold. Instead, the supplies held on tankers moved to the
market. As one trader told Platts, "it's now or never." As this sequence of events un-
folded, the world's commercial sector demonstrated that energy prices could be held
steady if politicians and regulators allowed commodity markets to function as they had
for over a century.10-002
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Verleger Comments on Federal Speculative Position Limits, page 32
The absence of any change in heating oil prices in 2009 and 2010 can be contrasted to
what happened in gasoline markets in the fall of 2005. U.S. gasoline production was dis-
rupted in September 2005 by Hurricanes Katrina and Rita. The disruption occurred when
inventories were particularly low. As a consequence, retail gasoline prices surged by 20
percent from $2.55 to $3.05 per gallon at the national level and as much as 30 percent in
the southeastern U.S. areas most affected by the disruption.
At the time, the United States was forced to appeal to its allies in the International Energy
Agency to replace lost production because private inventories were so low. Gasoline sup-
plies were sent to the U.S, from France, Germany, and Japan. These supplies helped
moderate the market disruption. However, the relief did not occur immediately because
the inventories were located up to 10,000 miles from U.S. markets. As a consequence,
consumers had to pay significantly higher prices for up to two months. The total cost to
American consumers may have exceeded $10 billion. This expense would have been re-
duced had U.S. product inventories been higher, and those stocks would have been higher
had passive investors been more active in the gasoline market.
As it happens, the ravages of Mother Nature occurred when the oil industry was in transi-
tion, making inventory accumulation difficult. A new gasoline formulation, refinery
blendstock for oxygenated blending, was being introduced and the NYMEX was bringing10-002
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Verleger Comments on Federal Speculative Position Limits, page 33
on a new contract. Open interest was very low and hedging was not easy.12 Thus price
increases would have been likely even if markets had been functioning well at the time.
X. Effect of New Position Limits: Frustrated Inventory Accumulation, Increased
Price Volatility, and a Likely Boost in Consumer Prices
The Commodity Futures Trading Commission published draft regulations on January 14
to impose position limits on certain participants in petroleum markets.
131
will not de-
scribe the regulations in detail but rather focus here on two elements: the position limits
on swap dealers and the barring of traders with hedge positions from acting as swap deal-
ers. I will also note that the rules wilt drive business to foreign exchanges, which in turn
will cause inventories to accumulate abroad rather than in the United States.
First, the new regulations will impose position limits on swap dealers. In the past, swap
dealers have been the intermediaries between passive investors and the market, taldng
long positions on the futures exchanges in energy contracts while simultaneously taking
the short position of the passive investors. Under the proposed regulations, swap dealer
positions in the key energy futures contracts--natural gas, crude oil, heating oil, and gas-
oline---would be limited.
12 "Spot Gasoline Traders Still Waiting for NYEX/RBOB Changeover,"
Platts on the Net,
December 6,
2005.
13 Commodity Futures Trading Commission, "Federal Speculative Position Limits for Referenced Energy
Contracts and Associated Regulation, Notice of Proposed Rulemaldng," 17 CFR Parts 1, 20 and 151, RIN
3038 - AC85, January 14, 2010.10-002
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Verleger Comments on Federal Speculative Position Limits, page 34
Second, the regulations would prohibit traders holding "bona fide" hedging positions out-
side the spot month that exceed "an otherwise applicable all-months-combined or single
month position limit
''14
from functioning as swap dealers.
The first of these two prohibitions would limit the ability of passive investors to take long
positions in energy futures markets. To the extent this is the case, the rule would discou-
rage inventory accumulation. As noted above, the increase in the market's contango can
be traced to passive investment. The rise in contango in turn led to stock building. The
higher inventories have moderated price fluctuations. The proposed rules, by limiting the
activities of passive investors, will reduce these effects. Inventories will be lower and
prices more volatile.
The second element of the proposed regulations, the proposal to prohibit traders holding
bona-fide hedge positions from acting as swap dealers, will compound the problem. To-
day many large financial firms write options for energy consumers and producers. A bank
such as JPMorgan will write calls on jet fuel to United Airlines and puts on crude prices
to an independent oil producer such as EOG. JPMorgan may also act as a swap dealer to
a pension fund such as TIAA-CREF. (All names used here are chosen as examples. I
have no idea if JPMorgan deals with any of these firms.) JPMorgan and other financial
institutions need to access the futures market without limit to maintain these hedges.
14 CFTC, p. 54.10-002
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Verleger Comments on Federal Speculative Position Limits, page 35
Imposing the proposed position limits would have several impacts on JPMorgan, other
financial firms, other institutions such as airlines, and prices.
First, JPMorgan would have to withdraw as a swap dealer, as would other
institutions. This would force many passive investors from the market.
The number of longs would decline, contango could revert to backwarda-
tion, and inventories would decline.
Second, price ~volatility would increase. The market's reduced size would
almost certainly lead to greater price volatility.
Third, United Airlines' hedging costs (I use United as a consumer example
here) would rise as price volatility increases. Since airlines typically use
options to hedge their activities rather than futures, United and all airlines
would probably see their hedging costs go up.
Fourth, EOG would also see its hedging costs rise for the same reason.
EOG typically uses options to hedge risk and the costs of options would
increase.
Fifth, the decline in inventories would likely boost spot prices and price
volatility. End users such as airlines, average consumers, and those who10-002
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Verleger Comments on Federal Speculative Position Limits, page 36
heat their homes with oil would all see prices rise. The only beneficiary of
such policies would be oil producers, especially OPEC members.
These impacts would be primarily confined to the United States. Consumers in Europe
could benefit because there are markets located there that are not governed by the Com-
modity Futures Trading Commission. Passive investors could move activities to these
markets. In fact, some organizations have already shifted activities to London. The shift
will partially moderate the effect of the proposed CFTC rules.
However, the sh~t in mar-
ket activity will sh~ the location of physical inventories as well.
As I noted above, firms
tend to hold inventories close to the delivery point. Thus inventories of heating oil and jet
fuel will likely be higher in Europe and lower in the United States. This will leave U.S.
consumers more vulnerable to price volatility, just as in 2005.
I find all of these results to be contrary to the interests of national economic and energy
policy. Thus, I recommend that the proposed regulations not be adopted.10-002
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Verleger Comments on Federal Speculative Position Limits, page 37
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