Address of Sharon Brown-Hruska, Commissioner
Commodity Futures Trading Commission
UBS Global Oil and Gas Conference
June 3, 2004
Good afternoon. It's a pleasure to be here today to address this conference of the global oil and gas industry.
These are interesting and volatile times for the oil and gas markets. After quite an extended period of certainty and calm in the energy markets, we have moved rather quickly into a period of uncertainty driven by fundamental supply and demand factors including those related to energy supplies, the political situation in many of the OPEC countries, and the potential rise of the Chinese and Indian economies as substantial consumers of energy. These events have combined to raise prices and the volatility of prices to levels not seen since the early 1980's. And while we have yet to reach the peak real price levels we saw in the late 70's and early 80's, the relative quickness with which prices have risen from relatively low levels certainly has caught the attention of consumers, regulators, and politicians.
In light of these market conditions, I would like to focus today on the importance of markets in determining prices and allocating resources; the importance of risk markets like forward, futures, options, swaps; and what I believe the role of a regulator should be with respect to maintaining the integrity of the energy markets.
Before I get started, let me begin by telling you a little about myself and the Commodity Futures Trading Commission, but also let me state that the opinions and views I express here today are my own and do not necessarily represent those of the Commission or its staff. As for myself, prior to joining the Commission, I was an assistant professor of finance at George Mason University, and prior to that, Tulane University. In 2002, President Bush asked me to serve as a Commissioner at the CFTC, and I was confirmed by the Senate and began work in August 2002. Actually, this is my second tour at the Commission. While finishing my PhD, I worked at the Commission as a research economist for five years before moving into academia.
As a professor and researcher, my interests have always been in the markets. Markets make a compelling subject of study. Seemingly on their own, markets allocate resources by matching buyers with sellers at prices each side is willing to accept — this is what Adam Smith called the "invisible hand." And what is truly remarkable is that for the most part they do so exceedingly well without a regulator or some other operator there to lord over every price and every allocation of a resource. In fact, as the Russian, the Chinese, the North Korean, and every other centrally planned economy has shown, efficient resource allocation breaks down when planners get involved.
So as a regulator, and as an economist, I see my role as both a protector and promoter of markets. Unfortunately when prices or price volatility increases, such as has occurred with energy prices, there are often calls for the government to "do something." And by doing something that usually means interfering with the market process. We hear this today as some politicians and market commentators call for the government to do something about $2.00 a gallon gasoline, $40 a barrel oil, and $6.00 per million BTUs of natural gas. Fortunately cooler heads have prevailed thus far and we have avoided the disastrous economic experiment of price controls that we saw in the 1970's. But even so, the mere fact that we hear these continual calls to "do something" tells me that we need to be vigilant to ensure that wrongheaded policies do not creep into legislation or regulation that impede market users and prevents markets them from doing their job.
Alternatively, if we must "do something," the most effective thing we can do is to promote markets and innovations that allow them to operate more efficiently. As I have said, the markets that I regulate are the derivatives markets, which serve two general functions.price discovery and risk management. The futures markets are important price discovery markets because they can price commodities out into the future, which helps companies plan their investments. In fact, in a recent speech to the Center for Strategic and International Studies, Federal Reserve Board Chairman Alan Greenspan repeatedly cited the six-year forward futures prices for crude and natural gas as providing guidance to exploration companies.
But having forecasts of prices is one thing, as we all know price volatility is another thing. And that is where derivatives markets again come into play. The existence of futures, options, and swaps markets allow companies to lock in those forward prices and to make investments knowing that the financial results will be more certain. A recent article in the New York Times noted that Southwest Airlines has 80 percent of its fuel needs hedged for this year and 2005, and 30 percent for 2006 at prices below $30 a barrel. Similarly, Alaska Air has 40 percent of this and next year's fuel consumption hedged at $25 to $27 a barrel. So we see that when we have innovative markets and innovative companies, "something" can be done. Both Southwest Airlines and Alaska Air have "done something" about $40 a barrel oil—they have avoided it. And they have avoided high prices without the government having to step in to "do something".
Now of course there are those critics out there who would maintain that it is in fact these markets that have caused or at least exacerbated high prices in the energy markets. Some market commentators have alluded to the trading of funds, a term these days used to refer to speculators, as a source for high prices. While it is true that currently the funds are more actively involved in trading energy commodities, I challenge the assertion that these funds are somehow artificially inflating prices. Hedge funds, like any other participant, bring information and liquidity to markets whenever they trade. When they are speculating, they seek to make money for their clients by making predictions of market trends and movements, and trading on that basis. If funds do a bad job of predicting the markets, then they will inevitably lose money and find themselves out of the market. If they do a good job of predicting the markets, they inherently make the markets more efficient by their trading. But in addition to bringing information into the markets, which is a crucial part of the price discovery process, funds bring vital liquidity to the markets. This means that hedgers and risk managers like those at Southwest and Alaska Air are able to easily enter and exit the markets so as to accomplish their goals efficiently. Thus, I believe that the funds represent an important and fundamental part of the futures markets.
As for monitoring fund activity, like any other large trader in the markets we regulate, the CFTC monitors on a daily basis positions and price moves. In addition, the Commission is able to track the activity of funds as a group and to see how their positions add up on a gross or net basis. Finally, if we do see something unusual or which gives us cause for concern, the Commission is often in contact with these traders to the extent that any positions they hold would appear to be interfering with the smooth operation of the market. So any call to "do something" about fund trading, I believe would be misguided.
Looking beyond fund activity, as I mentioned earlier there are certainly fundamental supply and demand conditions out there that have combined to create this dynamic price environment. Perhaps the clearest statement of all in this regard comes from consumers who, while frequently shown in news broadcasts bemoaning the high cost of gasoline, continue to demand gasoline at a high level. Is it just I, or is there something ironic when we complain about high prices while filling 30 gallon plus gas tanks on our SUVs? My point here is that we must let markets work. As prices rise, consumers will adjust their demand. We saw it in the 70's and 80's when car buyers downsized in the face of expensive oil. We saw it in the 90's when buyers super-sized while awash in cheap oil. So I would argue that what we do not need today is interference in the markets that would seek to lower prices by releasing supply from our Strategic Reserves or other measures that would ultimately cost taxpayers dearly but do little to help discourage consumers from moderating demand and seeking ways to use scarce resources more efficiently.
All this reminds me of an example of how government interference in prices can produce nonsensical results. Its also fitting since it involves oil, even though the commodity directly involved is wheat. The story is this. Back in the late 1970's and 80's there was a kingdom that had a simple desire to be self sufficient in wheat production. There was only one problem. The country was a desert and fresh water was scarce. But while the country had little water, they had a lot of oil, and oil was valuable. So they sold the oil at high prices and subsidized farmers to produce wheat at up to eight times the world price. With such prices guaranteed for their wheat, farmers could afford to put in expensive irrigations systems and pump precious water into their fields. In the end they were successful. By 1984/1985, Saudi Arabia became a net exporter of wheat. Of course, this success has come at a high cost. Agricultural demand for water, which represents about 90 percent of total water demanded, has greatly reduced the availability and quality of water in the kingdom. In effect, Saudi Arabia, through its agricultural subsidy program, has undervalued its water and now runs the risk of running out. Without a sensible market price to guide consumption, as Ben Franklin said, "When the well's dry, we know the worth of water."
When it comes to markets then, I am unapologetic in my support for open and competitive markets. That said, it is not always the case that markets or participants in the markets function as we would like. We know that markets dominated by monopolies and oligopolies are not always conducive to efficient resource alloction. We also know that at times individuals may attempt to manipulate prices in their favor. Manipulated prices, like those for water in Saudi Arabia, do not allocate resources efficiently. If those manipulated prices are in the futures markets they reduce the efficiency of hedges, meaning that risk managers are less able to insulate themselves from volatile prices. Oftentimes the markets themselves will discipline the would-be manipulators, but at other times regulators must step in to ensure market integrity. And let me stress this point. When regulators "do something" about markets it should be to ensure integrity and not to affect prices. The markets will take care of prices as long as we take care of the markets.
Recently the Commission faced a situation where we felt it necessary to protect the markets from false price reporting and the attempted manipulation of natural gas prices. The Commission has aggressively pursued companies and individuals who manipulated or attempted to manipulate natural gas prices. Since 2002, we have investigated over 40 major energy companies and a number of individuals for alleged violative conduct. Thus far, the Commission has filed 17 actions and collected almost $200 million in civil monetary penalties. In some cases we found that traders were misreporting or engaging in wash trades to directly boost their personal profits. In other cases, traders were found to be attempting to manipulate the price indices to benefit the value of their company's position. In still other cases, traders indicated that they were pursuing a "defensive" strategy to counter the perceived manipulation of indices by other traders.
Regardless of the source or rationale for misreporting, it became apparent that something needed to be done to restore confidence in these markets. In cooperation with the Federal Energy Regulatory Commission and the Department of Justice, the Commission took action under provisions of the Commodity Exchange Act to penalize those entities and individuals who took part in the misreporting.
While the transactions in question did not involve futures contracts, the markets for OTC and futures are linked in important ways. Traders in one market tend to be aware of what is happening in related markets and incorporate the information they see in one market into the prices of other markets. In addition, traders at times hedge their market risk in one market with positions in the other. Thus, it is natural that the Commission took an interest in what was occurring in the OTC natural gas markets due to the potential that those prices could have affected natural gas futures.
The exchange-traded market, the OTC markets, and the cash markets are all linked together, financially and informationally. Thus, the Commission is given jurisdiction over the manipulation and false reporting of commodity prices, regardless of whether those prices are futures or otherwise. With respect to false reporting, the Commodity Exchange Act applies to "the price of any commodity in interstate commerce, or for future delivery on or subject to the rule of any registered entity." With respect to manipulation, the classic strategy involves intentionally creating artificial prices in one market to create a profit on a position in another market. Thus, Congress was judicious and clear in the Act in their intention that the Commission's jurisdiction included not only futures prices, but any prices.
Finally, because of the fallout from the Enron debacle along with the false reporting claims, the market for OTC energy contracts had collapsed from a perceived lack of integrity. We at the Commission felt that to restore integrity, we needed to act to assure market participants that market abuses would not be tolerated and that these markets were safe for participants who have legitimate and vital business to transact. 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.
As for our progress, I am happy to report that 97% of the energy investigations we opened in 2002 have been resolved. Furthermore, the remaining investigations that were spin-off corporate investigations from those in 2002 should be completed this summer. In my mind, this era in which many acted with a lack of integrity and violated our laws will soon be a part of history — one that will not be repeated as a result of our enforcement actions.
In addition to our enforcement actions, the Commission along with Federal Energy Regulatory Commission has sought other means to restore confidence in the energy markets. In the wake of the misreporting scandal and the collapse of Enron, two things came to light, and let me deal with them in turn. First, with respect to price reporting, we found that internal controls at companies involved in energy trading and the procedures at price reporting firms were often weak or even nonexistent. For example, prices were often reported directly by the traders. Such a situation tends to create an inherent conflict of interest when a trader realizes he has an opportunity to influence the indices on which his position will settle. In other cases, price reporting firms asked traders for their "sense of the trades" they were seeing in the markets. While there is nothing inherently wrong with providing a sense of the market, such market views come with limitations and caveats and should not be passed off as true market transactions, as they were in some cases.
To deal with the price reporting problems, there have been those who have called for an invasive government presence in the price reporting business. Some have called for the creation of a centralized data hub to which all natural gas, and possibly electricity prices would be reported. Under some proposals this would be a government-sanctioned entity with the power to force companies to report prices. In other scenarios, advocated by some in Congress, the hub would be a government regulator. As one can imagine, such an endeavor would be a huge undertaking as the regulator/data hub sought to ensure the integrity of prices in a widely diverse market. As an alternative I supported, and still do support, an industry initiative such as that proposed by the Committee of Chief Risk Officers, which establishes guidelines for reporting prices. I believe that such industry initiatives can be very effective in stemming the price reporting problems in a less costly fashion than by interposing a regulator into a job that the market can perform itself.
The second problem that became apparent with the collapse of Enron was the issue of credit risk. Prior to its collapse Enron was viewed as one of the better risks in the energy business. Following the collapse, not only did the industry realize that Enron.s credit was worthless, but it suddenly cast a pall on the creditworthiness of basically everyone in the industry. While many firms in the industry have strong balance sheets and can boast of solid credit ratings, the lion's share cannot. I believe that credit risk remains a significant roadblock in the recovery of the OTC energy market.
Following the Enron collapse the CFTC and FERC held several public meetings to discuss the problem of credit risk in the OTC markets and the possibility of a clearing solution similar to that used in futures markets. As commercial participants in the energy industry considered clearing of OTC trades, I know many 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 a strain on cash flows. Although a widely accepted clearing model has not yet emerged, there has been some progress towards clearing for OTC products and I believe that we will continue to make progress toward more general OTC clearing.
To date, we have seen clearing introduced for OTC swaps by the NYMEX and the Intercontinental Exchange, or ICE. Not surprisingly, however, the types of transactions that are eligible for clearing tend to be standardized contracts such as a Henry Hub natural gas swap. Down the road, and possibly in the near future, I believe that we will begin to see some innovative solutions which rely on more sophisticated financial engineering to mitigate credit risk. This may involve the management of price risks through portfolio techniques or structured products that allow clearing houses to sell off the price risks much as Fannie Mae or Freddie Mac are able to sell off mortgage risks through the sale of securitized assets. Other approaches, like the North American Energy Credit and Clearing Corporation, seek to integrate the physical and financial energy markets to reduce collateral requirements and eliminate receivable risk from pooled energy markets.
Now while credit risk and clearing solutions do not directly prevent manipulation or market abuses, these solutions do help create liquid markets. And ultimately it is liquidity that is the most effective preventative defense against manipulation.
First, it is the case that liquid markets generally mean a greater volume of trading. Take, for example the NYMEX light crude oil contract. This is one of the most heavily traded futures contracts in the world with more than 40 million contracts a year changing hands. This represents more than 40 billion barrels of oil. Because manipulating prices typically involves acquiring large controlling positions in either or both the cash and futures markets, an attempted manipulation of a market such as the crude market is a very expensive proposition to finance. This was a lesson that the Hunt brothers learned the hard way back in the 1980s when they tried to corner the market in silver.
In the early 1980's a group called the Hunt Brothers, a name not unknown to the oil industry, tried to pull off such a manipulation in the silver markets. Over the period of a year or so, the Hunt brothers drove the price of silver up by going long in the futures markets and taking delivery of physical silver. The problem for the brothers, however, was that as the price of silver rose, more and more supply kept coming to the market. Ordinary people were scouring their attics for any old sliver they could find. Eventually the brothers could no longer finance their position, the price of silver collapsed overnight, and the Hunts lost billions liquidating their high priced stocks of silver.
The other problem with liquid markets is that they tend to be populated with a significant number of traders who are, in addition, very savvy and well informed. Again with respect to the NYMEX crude contract, according to the CFTC's May 4 commitments of traders report, there were 188 large traders on the long side of the market and 172 large traders with positions on the short side of the market. A large trader in the crude oil contract is someone holding a position of at least 350 contracts, or 350,000 barrels of oil. The sheer size of those positions suggests that individuals or companies holding them have an intimate knowledge, or at least a large financial stake in the markets. Moreover, about 80 of the traders on each side of the market were commercial participants. So if someone is bent on manipulating prices in these markets they need to consider whom they are up against. It is extremely difficult to fool or gain market power over well-informed market participants in a liquid market.
That said, it is often the case that OTC markets involve customized transactions, so in a sense they are relatively illiquid in that there may be fewer counterparties with whom to trade, and to exit a contract one may have to return to the original counterparty to change terms. However, the markets for such contracts tend not to be considered susceptible to manipulation since prices for such contracts relate more specifically to the contract itself rather than to the broader market. These are bilateral deals between relatively large and sophisticated counterparties, and their proprietary nature means that the public interest here is limited.
So let me finish today by stressing a couple of points. The first is that we must have faith in markets and market prices. Without market determined prices we will inevitably fail to allocate scarce resources in an efficient way. Second, we must encourage markets to develop and integrate with each other to bring market pricing to as wide a segment of the economy as possible. Third, we must protect the integrity of the markets. As a market regulator, this is the most important part of my job — protecting markets. As we do so, however, and do so by not interfering in the market process, we also can promote the markets to perform their vital functions of price discovery and resource allocation.
How do we do that? 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 legitimate 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 active trading, whether for hedging purposes or for speculation, committing capital for intermediation, and engaging 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 well-being.
Thank you so much for the opportunity to share my thoughts with you today. I have enjoyed meeting many of you and I look forward to any questions you may have.