Building Liquidity and Integrity in the Energy Markets
Sharon Brown-Hruska, Commissioner
Commodity Futures Trading Commission
University of Houston Global Energy Management Institute
Executive Roundtable, July 15, 2004
Good morning. It’s a pleasure to be here today to speak to a forum consisting of university scholars and industry executives. As a business school professor myself, I always relished the opportunity to sit down with executives and entrepreneurs to discuss issues related to their industries and businesses. I seized upon such opportunities because they allowed me to avoid the “ivory tower” label and to stay grounded in the real world. The payoff was that I could bring a greater perspective to my students who would one day be let loose in the business world. As a regulator at the Commodity Futures Trading Commission, I face a similar challenge. It is far too easy for regulators to lose touch with the industries they regulate and to look out more for their own interest rather than that of the industry and the consumers impacted by regulation.
I am reminded of the time when I first worked at the CFTC as a research economist in the early 1990’s. The agency’s Office of Information and Resource Management had just finished setting up a network linking everyone’s Personal Computers together. At that time, Microsoft Windows, was still a rather new innovation and one that had not been in use at the Commission. Well, I was hired as part of a group of new economists and visiting academics that had already gained quite a bit of experience with Windows and we asked the computer folks to install it on our machines. After a good deal of back and forth on the issue, the computer folks relented and agreed to put it on our machines, but with a caveat. They told us that they would put it on our machines, but that they would not provide support for it and if we asked for too much help in using it they would remove it from our machines.
Now, at first I admit I was surprised by this. I always thought that computer people would delight in the opportunity to provide staff with the latest innovations in computing. So one day I mentioned my concern to one of the computer support guys. He told me, “You don’t understand. In the computer world there are two groups of people. There are software guys and network guys. The software guys are the innovators. The guys here are network guys.” I guess I still didn’t get it because I asked him why that would make a difference. After all, wouldn’t network guys also want staff to have the latest innovations, too? He explained to me, “No. Think about it. The worst thing that can happen to a network is for it to go down. And the way you stop it from going down is to keep people from using it.” Thankfully, our current computer folks at the CFTC are more forward thinking.
Well, the same thing might be said about market regulation. There is seemingly nothing worse than for something to go wrong in the industry you regulate. But in fact there is, and that is when you shut an industry down for fear that something may go wrong. From the day I had that conversation with that tech support person, I knew I was not a “network guy.” A network that no one uses is of no value to anyone. And an industry that is overburdened with regulations that discourages participation without confirmable benefit is of little value and high cost to its customers. For a regulator this is an important lesson, particularly for the derivatives markets, which offer such great potential to companies and individuals to manage the financial risks of their businesses.
Fortunately, the network manager mentality at the Commission has been successfully turned on its head under the leadership of the past two Chairmen of the Commission. In the late 90s, Bill Rainer, who now heads the OneChicago Futures Exchange, oversaw the reauthorization of the Commission, which culminated in the Commodity Futures Modernization Act of 2000. The significance of this Act was that it freed the Commission to regulate the derivatives industry in a more flexible and targeted fashion, as opposed to being bound by prescriptive and overly burdensome rules.
But passing the Act was just the first step. Following Chairman Rainer’s departure, Jim Newsome, our current chairman, enthusiastically picked up the ball and implemented the provisions of the Act. The result has been that the derivatives industry has grown significantly over the last four years, which is a great result for those needing to manage financial risk. I would also like to take the opportunity to further recognize Chairman Newsome’s contribution to the CFTC. As most of you are probably aware, Chairman Newsome has just accepted an offer to become president of the New York Mercantile Exchange. Personally I have enjoyed working with Jim over the past two years and I look forward as a Commissioner to carrying on the work that Jim has so successfully initiated at the Commission. I wish Jim well in his endeavor, and believe that the integrity and leadership he will bring to NYMEX will be of great value to that market and energy markets overall.
As you may know, soon after I joined the Commission, Jim asked me to focus my attention on the energy markets. Given the disturbing behavior we saw and the state of the markets at that time, I knew I was in for a challenge. And these are still volatile times for the energy markets. After quite an extended period of certainty and calm, 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 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 not reached 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.
As a professor and researcher, my focus has 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, 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 to “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, specifically hedge funds, 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 capital, 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. Thus, I believe that the funds represent an important and fundamental part of the markets.
A substantial amount of investment dollars have been pouring into alternative investment vehicles like hedge funds to achieve more diversification and risk-return profiling that is not possible in a securities-only portfolio. As many of you know, the Securities and Exchange Commission has come to recognize that the market is big and different, so they need more information. They yesterday passed, by a slim majority, a proposal to require registration of hedge fund managers as investment advisors, even though a significant majority of those advisors are already registered with the CFTC. Setting aside for the moment the existing and appropriate protections afforded to hedge fund investors by the commodities and securities laws, I cannot help wonder if the SEC realizes that they are taking a “network guy” approach to hedge funds. One way to ensure that nothing goes wrong on our watch is to chill the market and chase the business offshore.
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 proposals to “do something” about fund trading, should be done in consultation with the CFTC.
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 and business will make substitutions and adopt strategies to contend with the prices. 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 car 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 business and 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 irrigation 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 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. 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 22 actions and collected over $215 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.
The exchange-traded market, the OTC markets, and the cash markets are all linked together, financially and informationally. Thus, the Commission has 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.
In the wake of our actions, 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, 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, establishes guidelines for reporting prices. I have also been impressed with the accuracy and transparency of the information generated by the Intercontinental Exchange’s 10X Subsidiary, NYMEX’s Access system, and other market based systems. 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.
Many have asked me what is the best approach to preventing manipulation or market abuse; what tools does a regulator need? More disclosure? Greater capital requirements? No. While these are powerful tools, my concern is that they are “network guy” solutions. They significantly raise the cost of trading without the purported benefit of increasing regulatory effectiveness.
Going forward, and especially into the next year as we approach Congressional reauthorization, we need to be vigilant not to allow those who would turn back efforts to build markets to accommodate their own competitive interests or to accomplish their own political agendas. This is particularly true of the OTC energy markets, where a variety of proposals have been made and unsupportable revisions have been circulated to modify CFTC jurisdiction to a more prescriptive regulatory model and to expand CFTC jurisdiction in such a way that might jeopardize the legal certainty afforded to the principal-to-principal swaps markets.
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, or engaging in risk taking and risk management. These activities are so vital to our markets and our economy, that we must be careful not to adopt knee jerk prescriptions that can have a “network effect” and suppress market usage, driving business offshore and outside the reach of our jurisdiction.
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.