Thank you, Craig for that kind introduction. It’s a pleasure to have this opportunity to address the 4th Annual Energy Marketing & Trading Conference sponsored by the Global Energy Management Institute. Since the Institute was formed in 2001, it has been on the cutting edge of issues related to the energy markets and has served as an effective facilitator of dialogue between academics, regulators, and the energy industry.
My first exposure to the Institute came following the collapse of the OTC energy markets and the false price reporting that we uncovered in our investigations. At that point, there were a number of groups and individuals looking for solutions to price reporting problems and the liquidity drain that we saw in the industry. The Institute played a key role in stimulating discussion between the industry, the Federal Energy Regulatory Commission, and the CFTC. I will come back to that topic later in my remarks as there has been some follow-up in a report by the Government Accountability Office.
As I was contemplating my remarks here today, I looked back at an address I delivered in July of 2004 at the Executive Roundtable organized by the Institute. In that address I noted how politicians, market commentators, and certain commercial participants were making calls for the government to do something about high and volatile energy prices.
When I made that speech, gasoline was selling for about $2.00 a gallon, a barrel of oil was going for $40 a barrel, and natural gas was in the $6.00 per million BTU range. Today gasoline is roughly $2.50 per gallon, oil is about $65 per barrel and natural gas is about $9.00 per million BTUs.
The good news is that these prices are off their peaks. The bad news, at least as I see it, is that there continue to be efforts to impose more regulation on the futures and cash markets for energy products—veiled in a call for greater transparency in the market. As I will outline here today, I believe that the efforts to impose additional requirements on market participants are misguided. Yes, energy prices are high and volatile. But the measures being proposed, and some of which have gained favor in Congress, will likely do little to reign in prices and could actually lead to more volatility in the markets.
Before I continue, I would remind you that my comments here today represent my own opinions and do not necessarily reflect those of the CFTC or its staff.
Fact of Markets: Prices Move
The energy markets are in the midst of a boom that has not really been seen since the early 1980s. Whether or for how long the boom might last is not really for me to say. I suspect, however, that as we have witnessed with countless booms in various commodity markets over time, there will come a point where prices stabilize or possibly collapse. Whether they come crashing down or merely fizzle is difficult to predict.
For example, when we look back at the oil price boom of the late 1970’s and early 80’s, there were more than a few economists and market commentators predicting that oil prices would continue to soar as reserves dwindled. Instead, prices collapsed and then remained stagnant for a long period of time. In fact, on an inflation-adjusted basis, oil reached all time lows.
So I will avoid making any specific predictions, other than to say that what I expect will happen is that energy industry participants and consumers will react to current high prices. The industry will seek out new sources of oil and gas reserves; new technologies will be developed to squeeze more oil out of existing reserves; new sources of energy will be brought on line; there will be a renewed focus on nuclear energy; and consumers will demand and use more efficient technologies to conserve energy. In short, producers and energy users will react to prices.
Ultimately, we will observe what every introductory textbook in economics tells us: prices serve to allocate scarce resources in the economy. Prices tell us when to conserve and when to consume. Price discovery, which I have referred to as the life-blood of the free market system, occurs as the reactions of suppliers and demanders of the resource are continually impounded into market prices.
As a regulator of the futures markets, it is the CFTC’s role to protect that price discovery function--to make sure that the markets are fair and not subject to manipulation. And indeed, the Commission expends a significant amount of resources conducting surveillance of the futures markets. In addition, the Commodity Exchange Act (Act) also requires that the exchanges themselves monitor the markets for potential manipulation.
The output of self-regulation, both formally and informally, in the various industries we regulate help us get the balance right between the costs and benefits of regulation. Specifically, we rely upon the expertise of market participants and in-house compliance and regulatory agents, the incentives of market participants and managers, and the recognition by the vast majority of the same that the integrity of the market is perhaps its most valuable quality.
But even when markets work and are free of abuse, getting the right balance in regulation can be difficult for other reasons. One of the difficult things about regulating markets is that as economic fundamentals change; markets reflect the changes through price movements; and there is never a shortage of individuals or interests that believe that such movement reflects market abuse or manipulative behavior.
Producers and farmers think prices are too low. Consumers and processors think prices are too high. With respect to the energy markets, we have, nonetheless, received a number of inquiries regarding energy prices—several from members of Congress, a governor, and state regulators.
In addition to concerns raised to the Commission, as part of its reauthorization of the CFTC, the US House of Representatives has proposed a bill that would require increased CFTC scrutiny of the energy markets through increased market surveillance and reporting requirements. Other proposals that have been offered—though for the moment are tabled—are to restrict the amount that daily futures prices can move, place greater curbs on speculative trading and place greater control over the exchanges’ ability to design contracts. I might add, none of these proposals is necessarily novel. Over the history of futures trading each has likely been proposed or even adopted several times for a number of commodities. In the end, they have usually been determined to be ineffective and were dropped—but like the hydra of mythology, they keep rearing their ugly heads.
Today I would like to review several of these proposals and also talk about some of the work the Commission, along with FERC, has done that appear to have had a positive impact on the markets.
H.R. 4473—An Act
Late in the last session of Congress, the House passed a bill that would reauthorize the CFTC and is awaiting action by the Senate. The bill contains a section referred to as Title II—Natural Gas Price Transparency. If this section of the bill remains intact as it makes its way through conference there are a number of regulatory requirements that would be placed on the Commission as well as industry participants. Basically the requirements fall into two general categories—surveillance and reporting.
Let me begin with the surveillance requirement. As I mentioned, one of the functions of the CFTC is to conduct surveillance of the futures markets. What this bill would do would be to formalize and expand the Commission’s mandate to conduct surveillance of not just the futures and options markets, but all contracts for natural gas. The bill requires that in the event of a significant or highly unusual change in the settlement price of the natural gas futures contracts, the Commission must conduct a review of factors that caused the price movement. Moreover that review must consider the impact of—and let me emphasize this—any related contract, agreement or transaction in natural gas.
Some have noted that this provision of the bill merely preserves the status quo, and therefore does not place any new burdens on the Commission or market participants. The Commission already conducts market surveillance and also currently has the authority to obtain certain information on the cash market dealings of traders holding large futures positions. Nonetheless, this provision goes beyond the treatment accorded to any other commodity. It applies only to natural gas; it mandates reviews of the market under specified circumstances; and appears to give the Commission the authority to collect information on commercial activity in the markets on a regular and continuous basis, which it currently does not have the authority to do.
In addition to the surveillance requirement, the bill contains a provision that traders holding large futures positions maintain for a period of five years and provide on request to the Commission, records of the person regarding the position of any related contract, agreement, or transaction in natural gas to which the person is a party. And while the reporting requirement ostensibly applies only to circumstances where a manipulation is suspected, a section of the bill gives the Commission the authority to require routine reporting of these commercial transactions.
Again, while the CFTC already has some authority to obtain the information outlined in this provision, as with the surveillance requirement, the provision deals only with the natural gas markets and places a greater burden on market users than currently exists and goes beyond what applies to any other commodity.
Now one must ask, will these new provisions of the Act bring down prices or reduce volatility? I would offer that that is not likely. As I have said, the Commission conducts routine surveillance of the natural gas markets and to date has not found that there is any ongoing or widespread manipulation of the markets. Where we have observed what appears to be the exercise of market power or violations of the Act, we have investigated and moved aggressively to ensure the markets are free from abuse. The Commission’s surveillance staff has also analyzed several episodes of heightened price activity and has found that fundamental market factors are the key to explaining the price movements, not manipulation or excessive speculative activity.
Our Office of the Chief Economist also conducted an in depth analysis of the impact of large speculative traders—primarily managed money traders—in the energy markets. Hedge funds, which dominate this category, are often a target of the press, energy consumers and politicians. The results of the study found that money managers tend to react to the trading of hedgers and that their trading did not tend to drive prices. In other words, these speculators tend to supply liquidity to the markets. Thus, the often heard criticism that speculative trading has driven prices higher is not supported by the facts.
But this is not to say that all has been perfect in these markets. As many of you are aware the Commission brought over 32 enforcement cases for attempted manipulation and false reporting and has assessed over $300 million in civil monetary penalties. Through these actions the Commission has clearly established its ability and willingness to monitor the markets for this type of activity and to bring actions against wrongdoers.
Given the authority the CFTC currently has, it is not clear that proposals to expand surveillance and reporting in the cash markets, such as the one advanced by the House bill, constitute the right prescription. For one thing, such approaches are generally operationally difficult to implement and can do significant harm to the markets if they are done without regard to market structure.
In the energy sector, the market structure of the cash market is often bilateral, proprietary, and over-the-counter. It is not clear that forcing exchange-style transparency or requiring the details of private, individually negotiated transactions to be disclosed to the Commission is appropriate or effective in curtailing market abuse. Market surveillance of the futures markets works because the contracts are standardized and apply to specified delivery areas. On the other hand, trying to analyze the positions of myriad companies and individuals in cash markets is an infinitely more complex task and would require a significant additional commitment of resources by the Commission. We are a fairly lean operation already, and expanding our surveillance responsibilities to include cash market transactions would strain our resources, which are appropriately tailored and focused on policing futures and options markets. It also would create a significant moral hazard for the agency going forward, particularly if it is expected to police OTC and cash markets over which it has no explicit jurisdiction.
In addition, from the economist’s perspective, I know well that market structure can affect trading outcomes and market behavior. It is important to recognize the differences between centralized auction markets, like the futures markets, and bilateral, privately negotiated and brokered markets, like the cash and OTC markets. I would also offer that defining manipulation in a bilateral market is problematic. If we consider that these transactions are basically arms-length, negotiated transactions, it is not clear what would constitute a manipulation under the law.
But even if one believes that the reporting of information regarding cash market transactions is reasonable, we must balance that reasonableness against the potential costs of the requirement. While I wholeheartedly support a regulatory program for the exchange-traded markets like NYMEX that act as a source of significant price discovery and which is often therefore referenced by commercial entities and the public for pricing, I do not see the necessity of a prescriptive model for bilateral cash and OTC markets. Transactions in such markets typically do not serve as a source of price discovery as do exchange markets. They are more highly tailored and individually negotiated, therefore tending to be more diverse in nature and reflecting more idiosyncratic information as opposed to setting broad price levels. To effectively conduct surveillance would require an understanding of the nuances of every transaction.
In addition to the cost burden on taxpayers to support the Commission’s program to conduct market surveillance and to assure that companies are complying with the new requirements, we must also consider the cost on companies and individuals in the industry. As I mentioned, the bill would place reporting burdens and recordkeeping costs on the industry, which ultimately will be passed on to consumers.
And beyond the costs of complying with the new requirements, prescriptive regulation often inadvertently creates a disincentive to innovation. Consider that if you are a company that has developed a novel strategy for marketing gas, it may be the case that you will attract the attention of regulators. If one considers the cost of greater regulatory scrutiny, complying with information requests and the almost always necessary involvement of attorneys in such matters, companies may think twice. To avoid the burden of explaining themselves to regulators, such innovators may be inclined to forego bold actions for the sake of avoiding regulator scrutiny. Thus, we must be careful that what we may view as regulatory perfection does not become the enemy of the innovative markets.
Regulating from the Bully Pulpit
I would like submit a case study of where I believe regulators have been quite effective in improving the performance of the energy markets while avoiding the prescriptive regulations that are often so tempting to employ. I mentioned at the outset of my remarks today the role that the Global Energy Management Institute, FERC, the CFTC and the energy industry broadly, played in crafting solutions to the crises we saw develop in the energy markets over price misreporting and transparency issues.
In the futures industry, issues of price misreporting and transparency with respect to what underlies prices are typically not of concern. We know exactly what is being traded at exactly what price, and how many contracts change hands. Moreover, although there are requirements that exchanges publish daily information on prices, trading volume and open interest, the level of transparency in the form of real-time dissemination of market information exceeds that required by regulation since exchanges have a strong economic interest in publishing the information to encourage business to come to the exchange.
OTC and bilateral markets are somewhat different animals from centralized exchange-traded markets, however. The Intercontinental Exchange, which is an electronic commercial market, offers a high degree of real-time transparency via its publication of transaction data through its 10X subsidiary. In other cases, such as in bilateral transactions or voice brokered markets, there is no central organization like an exchange to standardize contracts, collect trading information, and disseminate it. But there still exists demand for the information contained in these transactions. As a result, a network of publishers developed that collect information from market users that voluntarily report their information, process it, and disseminate it back to the market.
Of course as is now clear, this model had no overseer to watch over the price dissemination process. In such cases it is usually up to participants in the markets to look out for their interests. However, participants in these markets not only did not bring discipline to the process but were part of the problem. But we must keep in perspective that competitive markets, and likewise the market for price information in natural gas, are rather recent developments. The natural gas market was not deregulated until the 1980’s and 90’s. Prior to that time, prices were set by regulators. As markets were restructured and competition took hold, we saw the development of markets for information that the industry could turn to to help form price expectations.
Reporting to market publications was voluntary and traders realized that it was difficult to validate the information they passed on to publications. It was also the case that many buyers of natural gas passively tied purchases to reported prices. This combination of circumstances led many traders to see an opportunity to profit by attempting to manipulate the indexes by misreporting transactions to their favor.
As the FERC, CFTC and energy industry began to look at this problem, another issue that came to light was that it was often difficult to assess what information really underlie prices that publishers were reporting. Were the prices indicative of one trade or a hundred; the result of an actual trade or only reflective of bids and asks in the market? Did prices reflect certain peculiarities to a transaction—its size or the delivery specifications? In short, the price index formation process was opaque.
As I said, this usually is not an issue in the futures markets, but it was certainly an issue for the cash markets and it had the potential to affect prices in the futures markets, where traders may rely on such market reports. As a result the CFTC and FERC worked closely to attack the problems and to involve the industry in developing a solution. FERC convened a number of conferences and workshops to look at the problem and invited the energy industry as well as the futures industry to participate.
Through the course of these deliberations a number of solutions to the problems of price reporting were considered. Some called for very prescriptive measures such as mandating price reporting to a government agency or a government endorsed entity. Others advocated the creation of a self regulatory organization and for FERC to delegate authority to such an organization or organizations to oversee the price reporting process. Some industry groups worked to develop a consensus on improved price formation within the existing system of voluntary price reporting.
Ultimately FERC adopted a market sensitive approach and issued a policy statement outlining what it expected of both price index developers and companies that report transaction data to index developers. But that was just the first step. Because price reporting was voluntary and some companies only saw the downside in the potential to inadvertently misreporting prices, FERC also created a “safe harbor” for reporting—a rebuttable presumption that companies that report trade data in accordance with the standards of the Policy Statement are doing so in good faith and will not be subject to administrative penalties for inadvertent errors in reporting.
The results of these efforts have been good. In March of 2004 FERC conducted a survey of market participants and more recently the Government Accountability Office conducted its own review of the natural gas and electricity markets. In each case they found that industry stakeholders now generally have greater confidence in price indices. They find that the quality of information has improved because more companies are reporting data to publishers and the publishers are providing more information about the number of transactions and volume of natural gas trades.
Conclusion: To Die by the (Regulatory) Sword or Live by the (Oversight) Carrot
In the end, I believe that the lesson learned is that regulators and the industry can work together to craft solutions to problems that arise without resorting to heavy handed regulation. Today I have spoken about two recent situations in the energy markets that in some way deal with transparency. In the first case, involving high energy costs, the call is to heighten surveillance and mandate more reporting purportedly to discourage and prevent manipulation. I respectfully disagree with the advocates of this approach, since I believe it raises jurisdictional and resource issues that create moral hazards for market users and the CFTC.
To the contrary, I believe the energy markets are more transparent, informative and free of the widespread manipulative and speculative behavior than ever. To the extent that abuse occurred, the efforts of the CFTC and FERC have effectively corrected it without resorting to a whole new volley of regulatory mandates
For critics of the markets, ultimately they must also have faith in markets and what they tell us. I do not think that mandates for greater transparency, more surveillance or constraining regulations will bring down energy prices—additional energy supplies and energy conservation will. That, precisely, is what the markets are telling us. To continue to blame high prices on manipulators or speculators denies and clouds reality, ultimately delaying our ability to deal with the more pressing supply and demand factors that need to be addressed.
Thanks you for your attention.
 See, Federal Energy Regulatory Commission, Report on Natural Gas and Electricity Price Indices, Docket Nos. PL03-3-004 and AD03-7-004 (Washington, DC: May 5, 2004) and GAO, Natural Gas and Electricity Markets: Federal Government Actions to Improve Private Price Indices and Stakeholder Reaction, GAO-06-275 (Washington, DC: December, 2005.)
Last Updated: April 18, 2007