Talk of curbing speculative trading in petroleum markets has the potential to bleed into the gas market, according to industry insiders, who warned that, despite the historically high price of commodities, the reining in of such players could have devastating effects on energy trading.

Connecticut Representative John Larson, a Democrat, said in March 2008 that he planned to introduce legislation to remove speculation in energy futures trading by requiring marketers to have the capability to take delivery of the product in which they are trading.
Prices continue to rise for energy products, reaching all time highs week after week.

Although aimed primarily at the petroleum markets, where the price of crude oil (see chart: NYMEX WTI crude 1Mo) has run largely above $100/barrel for months, the proposed legislation would reduce speculation in gas trading as well, he said.

"Prices continue to rise for energy products, reaching all time highs week after week," Larson said in a statement. "But, the demand for the oil and gas is not increasing. These costs are stretching wallets to the brink and making it hard for people to make ends meets."

Senator Byron Dorgan, a North Dakota Democrat, also questioned the issue of speculation in the oil markets, saying petroleum futures trading "has become an orgy of speculation" that has driven up oil prices well beyond what fundamentals might dictate.

Dorgan, for his part, suggested Congress increase margin requirements on the oil futures market, making it more expensive for traders to invest in petroleum commodity futures.

He said futures traders typically pay a margin of 5% to 7% of the commodity value, while stock traders can pay as much as 50% of the product's value.

"I understand the need for a futures market and I understand the need for liquidity in that market," Dorgan said (podcast: Speculative trading essential for energy market depth & liquidity ). "But what I don't understand is that people are buying oil even though they'll never get it from people who never had it, and making big profits as they run up the price of oil."

Deeming the prospects of removing or diminishing speculation in energy markets "ludicrous," Michael Haigh, director of commodity derivatives trading with Société Générale, said controversy in petroleum markets naturally tends to drag the gas market along for the ride as well.

"If one was just to remove this massive class of trader, there'd be no way to provide liquidity," said Haigh, a former economist with the Commodity Futures Trading Commission (CFTC).

From a marketer's perspective, Haigh said his trading floor typically does not see any consistent price movement in oil or gas as the result of the activities by a single class of traders.

"There's so much liquidity and such movement" among a wide variety of traders, from investment banks to hedge funds to end-users, "we'd know if one particular player ... was moving the market," he said.

David Schryver, legislative executive vice president with the American Public Gas Association, said that while his association does not typically track petroleum-related issues, some of his colleagues in the oil industry are certainly concerned about the talk to limit the activities of speculators.

"We think certainly speculators have an important role to play in terms of providing liquidity," Schryver said, adding that he has not yet heard a similar call to limit speculative trading in the gas market.

He added that improving market transparency, such as boosting the oversight capabilities of the CFTC, will be effective in deterring trading abuses and fraud - from speculative players or otherwise.

Jenny Fordham, director of energy markets with the Natural Gas Supply Association (NGSA), also said she has not heard any rumblings on the issue of gas market speculation since the CFTC held its September 2007 conference on exempt market oversight.

Fordham said the composition of the gas market, from physical supply sources to trading activity, is vastly different from that of petroleum markets and she touted the flexibility marketers have on the gas side.

"If you don't like what's going on in the futures or the financial market, you can do it elsewhere," she said. "The physical market is highly transparent and very robust."

Fordham said the gas market's transparency and liquidity has led to a high degree of confidence that the system is healthy. "If [traders] didn't believe the market worked, they wouldn't be participants in the market," she said.

The importance of speculative market players

Jessica Emond, director of communications with the American Gas Association, said volatility stems less from speculators and more from the inherent nature of the gas market - where demand can change quickly due to weather-related factors, while supply shifts occur at a much slower rate.

She said speculative players are vital, as they accept the volatility that consumers and producers are not necessarily as willing to shoulder.
Cash has been injected into the commodity markets by investors seeking to protect against anticipated inflation.

"Legislation restricting speculators, an important component of the commodity market, could actually increase price volatility," Emond said. "Additionally, a recent boost in pension funds investing in energy commodities may be affecting price volatility."

A paper prepared for Natural Gas Supply Association (NGSA) in October 2006 by Dr. Peter Locke, associate professor at the M.J. Neeley School of Business at Texas Christian University, similarly asserted that a lack of speculative players in futures trade could push prices far beyond fundamental values.

"Almost by definition, speculation leads to both positive and negative profits for speculators, although this fact is often ignored," Locke said, pointing to the massive gas market losses by failed hedge fund Amaranth Advisors in 2006.

"On average, speculation by managed money such as hedge funds [in the gas market] earns a small return, perhaps more than treasuries or the stock market, but typically not much more, especially as competition among these funds has intensified."

Instead, Locke believed many price inefficiencies in the gas market stem from state policies that restrict the hedge trading of local distribution companies (LDCs) - a "vacuum" that a speculative player might seek to fill (podcast: Speculative trading essential for energy market depth & liquidity ).

A reduction in trading restrictions on LDCs, he said, could potentially decrease speculative activity, as the market inefficiencies that speculators take advantage of would be diminished.

Philip Verleger, principal with PKVerleger LLC, believed the contribution of speculators in the recent rise in energy commodity prices has been exaggerated.

"Cash has been injected into the commodity markets by investors seeking to protect against anticipated inflation," he said. "The cash is not likely to be withdrawn."

Verleger said efforts to push speculators out of the market, such as Larson's proposed legislation, could, among other things, force out a greater number of speculative shorts than speculative longs, thus forcing up prices.

Subsequently, producer hedging would likely decline, thus compounding the price increase.

Economists agree that effective markets require both hedgers and speculators in order to function efficiently.

"While certain targeted controls on speculation are appropriate, speculators, as a class, provide the market liquidity to allow hedgers to manage various commercial risks," CFTC Chief Economist Jeffrey Harris told a Senate committee April 3 2008.

"Unnecessary limitations on the amount of speculation that an individual or an entity may engage in could limit the amount of liquidity in the marketplace, the ability of hedgers to manage risks and the information flow into the marketplace," Harris said.

Harris acknowledged that excessive speculation, defined by the Commodity Exchange Act as trading that produces "sudden or unreasonable fluctuations or unwarranted changes in the price" of a product, can be detrimental to the markets.

However, in the petroleum markets, Harris said commercial players are the entities who act first when new information comes into the markets, with speculators typically on the other side of that trade.

And while the cost of crude oil (see chart: NYMEX WTI crude 1Mo) has soared to record levels in recent months, speculators have done little to amplify this hike in price, he asserted.

"Simply stated, there is no evidence that position changes by speculators precede price changes for crude oil futures contracts," Harris said.

Harris' comments echoed separate reports in 2005 from the CFTC and NYMEX, who said hedge funds do not promote undue price movements in gas or oil futures trade.

In a study of gas futures trading in 2003 and 2004, CFTC said managed money traders, a category that includes hedge funds, would typically take the opposite position of traditional hedgers and, as a result, actually offset a larger degree of volatility in futures trading.