Commissioner Sharon Brown-Hruska
Remarks to National Energy Marketers Association
April 1, 2004
Thanks very much, Craig. Before I get started, let me thank Linda Radar and the sponsors of the Key Women in Energy Awards for their recognition. It is a real honor to receive this award and to do so in front of such an esteemed group that has worked so hard to champion markets for energy for the benefit of all of us. You all are participants in an important endeavor. Through your efforts to provide leadership, innovation, and risk taking, you make our markets more efficient and better able to meet the ever growing demands for energy by individuals and business, both here and abroad.
It is a pleasure to be here on the docket with the likes of Commissioner Nora Brownell and Chairman Pat Wood of the Federal Energy Regulatory Commission. I had the pleasure joining them and their new colleagues, Suedeen Kelly and Joe Kelliher, in a closed Commission meeting to discuss the recent price spikes in natural gas, market surveillance, and enforcement initiatives in the energy markets. In my view, this kind of cooperation between two agencies at the federal level is what good government is all about.
When I think of the horses of the Apocalypse that Chairman Wood described yesterday -- including the California energy crisis, Enron, supply concerns, and the Blackout, and I would throw in the list false price reporting -- to me one of the positives in tackling all those issues is that our two agencies have developed a very cooperative and helpful relationship. I have learned greatly about the gas and power markets, and frankly, I am inspired by FERC’s commitment, that of the state Commissioners from New York, New Jersey, Illinois, Pennsylvania, and others I heard yesterday, as well as this industry’s commitment to advancing open and competitive markets.
My agency, the Commodity Futures Trading Commission, is a small one – one that regulates the futures and options markets in the United States. The primary role of the Commission is to assure price integrity in the markets and to protect customers, and that has led us to be active in energy markets where abuses have occurred. As many are aware, since December 2002, the Commission has settled 13 administrative actions and imposed almost $200 million in fines against companies that reported false information on prices and transactions to energy price reporting firms.
Some of you may be asking why the CFTC is bringing these actions, and not FERC? After all, the misreported prices were for over-the-counter (OTC) physical transactions between private counterparties, not futures prices. Very simply, our authorizing statute, the Commodity Exchange Act, recognizes the integral link between the physical and futures markets and the potential for the manipulation of prices in one market to affect prices in the other. As a result, Congress granted the CFTC authority to take action against manipulators of any price of a commodity in interstate commerce. Asserting this authority signals to all that the markets are fair and free from those who would exercise market power to the detriment of business and consumers. The gas and power markets are too important to our economy, and as regulators, we are committed to ensuring market integrity so that both the exchange-traded and the over-the-counter markets are liquid and price efficient.
Many companies have come forward to report the findings of their own internal investigations and have cooperated with the Commission to determine whether wrongdoing occurred. This demonstrates that companies are anxious to put this chapter behind them, and get on with business. For our part, we are committed to completing our investigations by the end of the quarter. In my mind, the era of false price reporting will soon be a part of history – one that will not be repeated as a result of our enforcement actions.
Another area in which the Commission has an interest in the energy markets is in the area of credit risk mitigation. The collapse of Enron highlighted credit risks in OTC energy transactions and virtually dried up those markets overnight.
Before the fall of 2001, no energy company had better credit than Enron. After the collapse, no one was willing to go out on a limb out of fear that they had contracted with the next Enron. As a result, there has been a great reluctance to trade in the OTC markets. The energy markets in effect lost their most valuable asset -- their financial credibility. Most are concerned that counterparties might default on their obligations, or worse, that a default by one party might spiral out of control resulting in a domino-like collapse capable of taking out one party after another. The reaction has been to either not put oneself in the way of a falling domino or to make sure the domino knocking against you was small enough so as not also to bring you down. Either way, this has made for a smaller, less liquid market in OTC energy products.
One solution explored at the FERC- CFTC joint conference last spring, is the clearing of OTC trades. Clearing has been a central feature of futures markets since their inception. In futures clearing, the clearinghouse takes the other side of every trade and essentially holds a balanced book. To protect itself against individual defaults, it collects margin from every counterparty to cover short-term changes in the value of a contract, as well as additional funds as the market moves against losing positions. In addition, the clearinghouse retains the authority to liquidate any contract of a party that fails to post sufficient margin. The result is that there has never been a failure of a U.S. clearinghouse and they are extremely good credit risks.
As commercial participants in the energy industry considered clearing of OTC trades, I know many of you are skeptical that an exchange-based clearing model could work in the OTC energy markets. OTC markets are often not as liquid, contracts not as fungible, and quick settlements put strain on cash flows. Further, there seems to be a belief that clearing provides simply a financial guarantee, while merchant energy companies seek delivery guarantees. If delivery is not made, load servers face severe cost. In power, I understand that securing alternative delivery or taking offline, then putting back online, a cracking unit at a refinery is difficult and extremely costly.
I believe that innovation of traditional clearing models, whether through the provision of longer settlement periods, price differentials for differences in transmission and delivery characteristics, or specialized delivery requirements and procedures, can address the concerns of the energy industry, while providing an additional means to managing credit risk. Innovative clearing models for OTC energy products are available at New York Mercantile Exchange (NYMEX), the Intercontinental Exchange (ICE), and others. The Chicago Mercantile Exchange is looking to introduce a truly liquid market in credit derivatives that would allow market participants to hedge against a change in credit rating to help mitigate credit risk.
I believe that we as regulators, including FERC, the Securities and Exchange Commission (SEC), and the banking regulators, should encourage innovation by being flexible and working with firms and exchanges as they develop their products and their markets. Making sure that our regulatory environment does not stand in the way of such innovation ultimately will allow you to manage the entire suite of risks you face, lower risks and prices for consumers, and will help increase the growth and stability of the economy.
From my perspective, the blackout illustrated more than ever that markets are the key to spurring innovation and reliability in the energy sector. It is clear that the failure of the electricity grid can at least in part be explained by the lack of a real market for electricity transmission that would send proper investment signals and therefore provide incentives to modernize and bring integrity to the system.
Critics have attributed the current state of the grid to underinvestment in transmission lines and have blamed the Bush Administration for its commitment to deregulation and markets. While underinvestment in the grid is an issue, underinvestment certainly has nothing to do with deregulation. Remember that this nation’s power grid was built and has been maintained for the better part of a century under perhaps the strictest regulatory control of any sector of the economy. President Bush has been in office for just three years. A power grid is not built, or even significantly modified, in three years. Moreover, while there has been some progress in instituting competitive wholesale and retail electricity, transmission markets have lagged behind. If anything, the state of the power grid is an indictment of the effect of over regulation, not deregulation and competition.
As Commissioner Brownell mentions, it is not if we can develop markets in electricity, but when we are going to get competitive markets up and functioning properly. I would add that as real competition comes to the energy markets and firms face uncertainty created by price volatility, derivatives are the key to helping producers and consumers manage price risk and bring stability to the industry. Derivatives, in the form of futures, options, and swaps, give companies an array of tools for managing price risk. Through these instruments, price risk can be shifted from parties that do not want it to parties that are willing to hold it in hopes of profiting from it. Speculators, including floor traders in the pit, hedge funds, banks, and energy traders, are crucial to our markets because they provide liquidity by taking on price risk from hedgers, such as a utility or a gas marketer, wanting to shed it.
So while many of us worry about where prices are going and how to manage the uncertainty of price changes, derivatives make price risk manageable. Moreover, the stability that can be achieved through their use will aid firms in attracting more investors and capital to the industry.
On the consumer side, the use of derivatives makes it possible for local utilities and gas companies to offer their customers the benefit of stable and predictable prices. As an example, heating oil companies in my area often offer retail customers the ability to lock in a fixed price during the winter season. The companies are exposed to the risk that the price of oil at the time they deliver it to their customers will be significantly higher than the contract price. So how are they able to offer these deals? One way is by using derivatives. If the company purchases a heating oil futures contract at the time they offer the fixed price, gains on the value of the futures contract if prices rise will cover the loss on the physical oil sold to their customers. The companies lock in their margins and customers benefit from the certainty of fixed prices.
While derivative instruments offer powerful opportunities for companies and individuals to manage risks in a competitive economy, regrettably they have often been much maligned. This is in part because derivatives are perceived to be complex, and therefore a bit scary to the uninitiated. Also, in free markets, derivatives are often the first to reveal the reality about the underlying economic fundamentals of scarce resources. This raises suspicion that derivatives are to blame for price change. Indeed, many on Capital Hill have pushed both the CFTC and the FERC to investigate price increases in search of manipulation or avarice.
While I cannot comment on any specific investigation, I would note that in our weekly surveillance briefings on the gas and crude oil markets, there is a lot of evidence that simple economic fundamentals are what is behind the price movements we have seen in the last six months. Particularly with respect to natural gas, we experienced an unusual gap between expected storage drawdowns and actual storage that gave rise to significant uncertainty during the winter months. Futures price this kind of uncertainty. We also see that demand for and the price of a close substitute to natural gas, namely crude oil, is at record levels. Unless demand abates, and this applies to what we pay at the pump, prices will continue to remain high.
While there has been a tendency to focus on US demand for energy, I do not think we can ignore the growth in worldwide demand for energy, particularly from China. As a Commissioner at the CFTC, I receive a weekly briefing from our market surveillance staff on the various commodity markets we regulate. One thing that has not escaped my notice, week-in and week-out, is the influence that China is beginning to have in the commodity markets. Whether the commodity is soybeans, rice, copper, cotton or petroleum, what we are seeing is that China is beginning to run trade deficits in all of these commodities and this is beginning to drive their prices up. Now if we stop for a second to consider the size of China's economy versus its potential, we begin to see more clearly what an impact their demand is having on prices.
So what can we do? One thing is to pass a coherent energy bill along the lines of the President’s plan that encourages innovation, exploration, and conservation. Another is to let the markets work. Many of you have heard the comments that I gave to the Power Industry Forum last year, where I was quoted as saying, “Buying low and selling high is not a crime.” The energy markets, in particular power, natural gas, and crude oil, have been battered by one accusation after another that manipulation has occurred whenever prices move. I believe that this creates a negative atmosphere where trading is curtailed because companies do not want to constantly have to look over their shoulder to see where the next salvo is coming from.
I believe that we as regulators must be careful not to impinge upon the kind of market activity that occurs when market participants provide liquidity by posting quotes, commit capital, and engage in risk taking and risk management. These activities are so vital to our markets and our economy, that we must be careful that when we see price swings, we don’t shoot the messenger for delivering the message. The message is one about supply and demand, and the messenger is absolutely essential to ensuring our economic health and wellbeing.
Some lawmakers have proposed re-imposing a wide range of regulatory prescriptions on OTC derivative markets that would provide little protective benefit to the markets and its participants, while imposing high costs. Regulators have been criticized for not moving quickly enough, yet, without good information, or a complete understanding of the markets, quick regulatory or legislative action poses a greater risk. “Knee-jerk” responses are not helpful in solving real or perceived problems, but rather tend to create significant costs, not only for the industry, but also for government and taxpayers. Moreover, if the regulatory response is to cripple the market, this will deny vital risk management tools to this industry, punish the innocent by curtailing legitimate business activity, and ultimately, the economy will suffer.
It is my view that the enforcement actions that the CFTC has taken against natural gas traders who have misreported prices and transactions, or attempted to manipulate markets, have been prudent and effective as a deterrence to further abuses. The CFTC, in increased coordination with FERC, has used every tool at our disposal to monitor and ensure that the markets we regulate are able to perform their vital function free from fraud and manipulation. Please be assured that I will continue to champion competitive markets as we work together to stabilize and strengthen the energy sector.
During the blackout, President Bush quickly reassured our nation that his Administration would make every effort not only to investigate the problems in our energy markets, but also work with all interested parties to solve them. As prices have risen in response to fundamental economic forces, the Administration has been equally proactive in advocating realistic solutions to our nation’s energy challenges. It is my sincerest hope that each of you will lend your support to the eventual passage of the President’s energy plan, ensuring our energy security, and ensuring that this market will continue to keep pace with the rest of the economy.
My sincerest thank you to each of you, and especially to Craig Goodman and the National Energy Marketers Association for the opportunity to share my thoughts this morning.