Yesterday the Commodities Futures Trading Commission filed a civil enforcement action in U.S. federal court charging that Amaranth Advisors LLC and former head trader Brian Hunter tried to manipulate the natural gas market. Amaranth's actions, according to an earlier Congressional report, resulted in abnormally high gas prices for consumers. Amaranth lost $6.6 billion in the biggest hedge fund failure. By comparison, the Bear Stearns debacle, in its sub prime credit funds, may not be far behind, and may well nose ahead when all is said and done.
Clearly, the exchange traded natural gas markets are aware that they are under the watchful scrutiny of the CFTC. They have been gyrating, as markets are wont to do. From a high in November 2006 of $9.05 MMBtu to prices sliding to less than $6.00 MMBtu today. Gas is trading at prices reflecting the unfettered and transparent conditions of the marketplace, in this case responding to excess inventory, cooler summer weather, the prospect of impending LNG supplies and, of course, the Amaranth debacle, that if nothing else, has now alerted the industry that the CFTC is on the prowl.
But then again there is the case of Sherlock Holmes's dog not barking. By that I mean the price behavior of crude oil. Yesterday's weekly oil stats came out and showed a decrease in crude oil inventories of 1.1 million barrels, a drop that was less than what had been anticipated. If you are not going to use up your oil inventory at the height of the driving season, when then? And more pointedly, oil inventories are up over five percent than those of last year, and that doesn't even count the more than 700 million barrels we have in the Strategic Petroleum Reserve (I know, its sacrosanct and we shouldn't use it until...? But it's there nonetheless). And so, what happens? The price of crude oil goes up by some $2.50 a barrel. No shortage here, in fact ample supply, and yet we see a price popping past $76/bbl. on the trading exchanges.
Now back in November 2006 with natural gas prices hitting their recent high of $9.05mm Btu, the price of crude was in the low $60 a barrel. Oil inventories have been and are consistently higher than they were the year before, and in general oil inventories are at levels higher than their five year average. On January 23 of this year, the date of President Bush's State of the Union Address prices had just touched $49.90/bbl but quickly recovered on the President's announcement that the Strategic Petroleum Reserve would be doubled. Then came the daily staccato of announcements over strife in Nigeria, curtailment of shipments from Angola, rants in Teheran and the plethora of daily scenarios being trotted out by the oil producers and their allies, none of which, would they have had any real impact, couldn't have been resolved with the turn of a tap by the Saudis. But a 50 percent jump in price within in six months, without any evident cause justifying such a steep price escalation, raises the specter of manipulation and an CFTC asleep at the switch.
In my early trading days, before so many commodities became transformed into "commodity contracts" on trading exchanges you bought and sold the physical product. Industrial buyers or trading houses bought product directly from producers or trade suppliers at negotiated terms including price, quantity, delivery schedules, payment conditions and on. The product would then be transported to, or lifted by the industrial end buyer such as the refinery or chemical plant. You knew the market structure of the commodity under negotiation, you knew the producer and the end buyer, and within broad parameters the market did as well. This transparency was the markets own discipline.
Today we are dealing with commodities that are in effect futures contracts, technically termed "exchange traded derivatives" (ETD's) in that they are contracts for the supply of , say, oil, without any sense of who the producer of the oil might be, and unless you happen to be the end consumer, who will be using the oil, nor for what (gasoline, fuel oil, heating oil and on).
For those trading in the current market the price of the commodity is now the objective. Not commercial relations, not establishing your reliability as a producer/supplier (meaning not raising the price of your product by 50 percent in six months) or as a consistent industrial partner. There is now no focus on the pricing policies that were key to establishing solid commercial relations in the long term between producer and end buyer. Today that focus has been altered to the time frame of today's exchange traded price. In today's world those relations have even evaporated to the point where among many institutional investors and hedge funds, 'black 'boxes' are programmed with algorithmic equations initiating automated trading programs at predetermined buy and sell price points. It has become clear that even though one may be dealing 'in' a commodity, in essence you are trading in the value of a piece of paper, the futures contract ( or ETD).
As regards oil, that "contract" can be negotiated electronically on the Globex, on the New York Mercantile Exchange, in London on the "ICE," or Singapore, or Hong Kong. Trading in these markets are often opaque, the markets not being aware of the identities of neither buyer nor seller. They are also subject to enormous leverage. Witness Amaranth, and at the risk if mixing apples and oranges, Bear Stearns. A single trader, given the leverage available to him can have enormous impact, for profit or disaster. It begs the question, what about manipulation?
It stands to reason if you are an oil producer or a hedge fund trading in oil, you have a major stake in how oil is priced. If you can push up its price by simply taking a position in exchange traded derivatives and thereby setting a market recognized price level favorable to your interests, without directly confronting or having to deal with your long term customers or spot buyers on this issue, well you have found nirvana. All the while your trades can be executed anonymously and without oversight (Amaranth did much of its trading on London's 'ICE" exchange to circumvent U.S. constraints), and the public and your customer base is made to believe that the escalating prices of oil is the work of the 'invisible hand of the market". The temptation to play the market in this way would be enormous. This especially if your means, as with OPEC producers, are almost limitless and no matter how big or wide the market may be, it could not withstand the power of the resources at your disposal. This is all hypothetical. Of course!
In actuality the prospect is not at all that far fetched as evidenced by the CFTC's filings against Amaranth alleging manipulation in the trading of natural gas contracts. The time has come for the CFTC to redouble its attention to the oil markets as well. They must try and get behind the major trades; who is buying or selling. To bring as much transparency to this commodity's trading as we have for stocks and bonds. To cooperate and persuade the non American exchanges to share information, and to be wary of producers trying to fix prices through the clandestine world of futures trading. Amaranth has taught us how one trading house can lose billions in trading. The CFTC must be equally vigilant to the possibility of those making excessive and unearned billions by rigging the game of oil trading at enormous expense to the public at large. With the disappearance of the commercial traditions and discipline that once existed between buyer and seller, the CFTC is our only line of defense and it must be given the tools by Congress to police the energy markets in the United States, most especially the electronic trading platforms. It must be given the mandate to cooperate and persuade offshore exchanges to jointly achieve transparency and to establish rational position limits that can no longer distort the free functioning of the trading markets. The unconsciousable transfer of wealth to oil interests must stop.