Does the Tail Wag the Dog? The Case of Natural Gas Markets
Speech by Dr. Sharon Brown-Hruska, Commissioner
U.S. Commodity Futures Trading Commission
Natural Gas Roundtable of Washington
March 28, 2006
Good afternoon. It is a pleasure for me to be here today to address the Natural Gas Roundtable. I would like to share some thoughts with you on markets—specifically the futures and derivative markets—and the role that my agency, the Commodity Futures Trading Commission (CFTC), plays in regulating them. Before I get to that, let me note that the views I express today are my own and do not represent an official position of the Commission or its staff.
When I look at today’s natural gas markets and the concerns and issues being raised, I cannot help but to recall an earlier case involving the stock market. As you may not know, my career at the CFTC actually began in 1990 as an economist in what was then the Division of Economic Analysis. At that time, the agency was dealing with the fallout from the stock market crashes and assertions that trading in the stock index futures markets led to the fall of stock prices—particularly in the case of the 1987 episode when “program trading” was fingered as public enemy number one.
Back then, we referred to these assertions as the “tail wagging the dog” theory of markets. In this theory, trading activity, particularly speculative trading, in the relatively small futures market could carry enough weight to drive prices in the relatively large cash security markets to unreasonable levels. Today we see many of the same charges being leveled. This time the charge is that excessive speculative trading in the energy futures and over-the-counter (OTC) markets is leading to higher prices and volatility in the physical energy markets.
As an aside, let me note that it is not just the securities and energy markets where we see these kinds of assertions. In May 2004, the Director of Market Oversight at the Commission took the very unprecedented step of issuing an open letter to a group of silver traders—some 500 of whom sent letters and e-mails to the Commission—addressing their assertion that the silver futures market has been the subject of a 20-year-long manipulation by a group of commercial traders. What is interesting and different about silver is that normally we see charges of manipulation when there is a large price spike or collapse in the market prices. In silver, the charge is that there has been no price appreciation for an extended period. For anyone interested in reading the letter— I would highly recommend it since it is a fascinating story that provides insight into the kind of surveillance work and market analysis we do at the Commission. The letter is on the CFTC website (www.cftc.gov/files/opa/press04/opasilverletter.pdf).
Initially, the question I want to attempt to answer is whether the futures market tail is wagging the physical market dog. Further, as a corollary that controversial question, what happens if we cut it off? To answer that question, we need to consider the functions of the futures markets. There are two vital functions that a futures market performs—and let me foreshadow a bit here by saying that these functions are linked. First, futures and OTC markets, or for that matter any derivatives contract, allow participants to shift price risks. This is hedging—where a price risk is being shifted from a commercial party to another commercial party or speculator that is willing to assume the risk. Commercial market parties, as participants in the physical markets, are generally considered well informed regarding market fundamentals, and the prices at which they are willing to trade will reflect their information.
The second function that futures markets serve is price discovery—and this is where we start to see the importance of the tail of the dog. Traders in futures markets are rewarded for being right about where prices are going. And the price that they need to be right about has to be that which is determined by factors in the underlying physical markets. Why? Because recall that I said that futures markets are used by commercial parties to hedge transactions. If futures markets get out of line, physical market participants will enter the futures markets with a vengeance to bring prices back into line.
Again, the link between futures markets and commercial activity will assure that futures prices reflect information about the underlying physical market. If they do not, the question then becomes: is there a problem with that information or are there problems in the physical markets that regulators need to address?
To illustrate what I mean, consider the activity of the Hunt brothers in the silver markets in the late 1970s and early 80s. The Hunt brothers were convinced that silver was undervalued. They saw an opportunity and began to accumulate massive quantities of silver stocks. The more they bought, the more expensive it became to acquire; and the more expensive silver became, the more silver supplies flowed into the market. Due in large part to their accumulation of physical silver, futures prices rose from about $2.00 an ounce in the early 70s, to peak at $54 an ounce in 1980, before collapsing in dramatic fashion.
What this example illustrates is that first, futures prices reflected market fundamentals—i.e., the hoarding of silver by the Hunt brothers. We also saw a strong reaction to prices on the part of economic agents. During the silver run-up, not only did commercial enterprises boost silver production, but ordinary citizens flooded the market with whatever silver could be found in their basements and attics. This made it costly for the Hunt brothers to continue to build on their position. Noting that the Hunts were unduly influencing the market, the exchanges and the CFTC took action that forced the Hunt brothers to sell off their silver holdings. Once that happened, the price of silver collapsed reflecting the abundance of silver in the markets. Market forces and regulatory intervention conspired to break the Hunt brother’s hold on the physical silver market.
In general, prices provide strong incentives to economic agents to make adjustments. Even in the case of a strong cartel, such as OPEC, we routinely see members cheating on their production quotas in order to maximize their revenue. Over the long run, this ultimately leads to lower prices.
One should also note that in the case of the Hunt brothers or OPEC activity, we are talking about situations where activity in the physical markets is responsible for affecting futures prices. In fact, in practically all cases where we see problems in the pricing process, and certainly where longer-term prices are in question, there is typically an explanation to be found in the physical markets.
The idea that a group of speculators can simply enter the market, buy up futures positions, and sustain a long term manipulation of the market, defies logic. For one, futures contracts have a finite life. So whatever long or short position is established, it must be unwound prior to the expiration of the contract. In this case, prices are governed by the law of gravity—what goes up must come down. Secondly, when speculators enter into futures contracts, all they have is a price play. They do not actually have a position in the underlying commodity, so they are not able to tie up inventories, thereby making it unavailable to the market. Thus, their trading does not create shortages that could serve as a mechanism to drive prices up. This can only be accomplished in the physical markets.
As further evidence that speculators in the natural gas markets are likely having little effect on rising natural gas prices, we can look at the activity of managed money traders or hedge funds, the largest group of speculators in the market. This group of traders has often been identified as a group that is responsible for pushing prices up or making them more volatile. While these charges may make for good headlines, the facts do not support them.
Indeed, managed money traders represent a significant amount of trading that takes place in the market. But as with most groups of speculators, the group is composed of those who take long positions because they believe that prices will rise and those who go short on the belief that prices will fall.
A review of managed money trading activity back through the beginning of December, when futures prices peaked at about $15 per million Btus, shows that the group has held a net short position in the futures and options markets. On average that short position is about
thirty thousand contracts, as compared to an overall average open interest in the market of more than one million contracts. Moreover, if we extend the analysis to the physical markets, the annual consumption of natural gas in the United States is equivalent to NYMEX open interest of about 2.1 million contracts. So while managed money trading may involve large individual outright positions, as a whole their position is opposite of what would be expected if they were exerting upward pressure on prices, and overall it represents a small part of the market. In essence, speculators are part of the tail on a big, active, bounding dog.
As a regulator, and in particular as a regulator of a derivatives market, my role is not to influence market prices, but to assure that the markets are free from fraud or other abuses. When regulators or governments ignore this and get into the price setting business, the results are predictably disastrous. Simply look at the old Soviet Union to see what happens when you try to dictate prices. You wind up with oversupplies of some goods and extreme shortages of others.
So we need to rely on market mechanisms and the prices signals they emit and not attempt to artificially influence prices. This brings me back to the current state of the natural gas markets and critics who believe that prices do not reflect fundamental market conditions. The problem with the analyses that I have seen to date is that they usually begin with the conclusion that prices are too high and then attack those prices through rather simplistic and static analyses of market fundamentals and relationships.
For example, a recent report on the natural gas markets challenges the assertion that demand for gas has risen over the past decade. The problem with the analysis, however, is that demand is equated with observed consumption. But as any economist can tell you, when supply is constrained—which is the case with natural gas—and demand rises, consumption remains flat because there are few additional sources of supply. If there is only one apple left in the grocery store, I can only eat one apple no matter how badly I would like two. And if there is someone else in the store who wants that apple, he has no choice but to eat an orange. We will talk later about comparing apples to oranges, but...
In this example, prices adjust to reallocate scarce supplies. And, in fact, this is what we observe in the natural gas markets. Consumption of gas by electricity generators and retail customers has risen, even at higher prices, while other industrial users have switched their consumption to oil, or as has been the case with a large number of U.S. based fertilizer producers, have been forced to leave the market because natural gas is the main feedstock for production.
Another element of the analysis that I find flawed is the seemingly obsessive focus on gas storage figures. The argument goes something like this. The amount of gas in storage this year is the same, or even greater, than last year. Therefore prices should be the same or even lower than last year. Why then are prices so high?
The problem with this analysis is that gas storage is really meant to deal with the short-term allocation of gas. Stocks are built during the summer and consumed during the winter. Stocks serve as the buffer to cushion against demand spikes from cold weather. If colder than normal weather persists, prices rise to try to stretch consumption over the remainder of the heating season. Moreover, if the heating season appears to come early, as what looked to be the case this year in December, prices can rise quite precipitously. What we know is that without a storage buffer, prices would have to adjust even more radically to curb demand.
In the larger picture, though, the price of natural gas is driven by what it costs to initially extract gas from the ground, the cost to ship it, and ultimately by how much is in the ground. If it is expensive to extract and supplies are few, prices rise.
The situation that we seem to have reached in this country is, at least in the short-run, there is not a whole lot more gas than can be quickly brought into production in North America. That means that we need to look to LNG as an import, which is more costly, due to the needed transportation infrastructure, than domestically produced gas. A second alternative, as in the case of fertilizer, is that gas gets imported in a different form.
These are a couple of observations I had, but if you would like a better more complete analysis I would recommend the presentation that Steve Harvey with the Federal Energy Regulatory Commission (FERC) did at the March 16, 2006 open Commission meeting a couple of weeks ago analyzing some of these reports and pointing out many of the flaws in the analysis. And if you have not seen his analysis, FERC has an archive of the meeting that you can watch on their website, and Steve does an excellent job of describing market fundamentals at play here. The only prognostication that I will make as to what the price of gas should be, is to relate to you a quote by Benjamin Franklin. “When the well’s dry, we know the worth of water.”
While the CFTC does not regulate the price of natural gas, it does monitor activity in the futures markets to ensure that prices are not manipulated. There are two ways that we do this. First, we review the terms of contracts listed on the exchanges to make sure that the contracts themselves are not susceptible to manipulation. For example: Is the deliverable supply of the commodity specified in the overlying contract sufficient enough to avoid the possibilities of corners, squeezes, or delivery congestion? Contract review used to be a very slow and formal process whereby the Commission had to approve every futures contract before it could be listed. Today, the Commission still reviews each contract, but contract markets have been given greater latitude to certify that their contracts and rules meet the core principles of the Commodity Exchange Act and list them for trading without CFTC pre-approval.
The second way that the Commission monitors the market is through its market surveillance program. The Commission maintains a staff of economists and market analysts who constantly monitor traders’ activities and positions in the markets. The primary way they do this is through the CFTC’s large trader reports. Basically, every trader in the market is required to report its futures position daily to the CFTC when that position is larger than a specified amount.
For instance, in the natural gas market, a position becomes reportable when it reaches 175 contracts, which is the equivalent of one-and-three-quarter trillion Btu’s of natural gas. With this large trader information, surveillance economists determine which traders hold the largest positions and they continue to monitor the positions as the contract enters the delivery period and trading begins to wind down. During this period, staff economists are looking to see that positions are being liquidated in an orderly manner. The economists also want to know whether the parties holding large positions can either make or take delivery on the contracts. For instance, they will talk to the large shorts to determine whether they have access to gas that they may need to deliver, and talk to the long traders in the market to determine whether they intend to stand for delivery or whether they will liquidate their position.
The economists also monitor the physical markets at the delivery points to assure that transportation facilities are in order and that other conditions that could potentially lead to delivery congestion at the delivery point do not exist. If and when concerns arise, the CFTC economists along with those at the exchanges will meet with the large traders to address those concerns.
To date, the Commission’s surveillance programs have worked well to deal with potential manipulation and delivery problems in the markets. The primary reason why it works is due to the centralized nature of the futures markets and the standardization of the contracts. Because of these factors, it is easy to aggregate a trader’s position to know precisely how much gas he controls for delivery at a specific delivery point, at a specific time, and of a specific quality of gas.
Recently there have been some proposals that would require that the Commission apply a similar surveillance model to the broader natural gas markets, including contracts for physical delivery as well as the OTC derivatives markets. While the efforts behind these proposals may be well intentioned, attempting to construct such a surveillance program that would be effective in identifying and preventing market manipulation would be extremely costly and not likely to produce much benefit.
The problem with attempting to monitor the natural gas markets generally for manipulation is there are a myriad of transactions that are not easily aggregated, and in terms of pricing, may be difficult to compare from one transaction to another. For example, if I am trying to determine why two transactions in the OTC gas market have different prices, I need to consider a number of factors including location differences; differences in the size of the transactions; quality differences; transportation costs; local supply and demand factors; differences in the negotiating skills or special needs of counterparties; and differences in the creditworthiness of the parties involved in the contracts.
Any of these factors and others would need to be considered to reach a reasonable conclusion that price differences may be the result of an attempted manipulation. In the futures markets, these differences are for the most part eliminated and evaluating prices and positions is more effective. Thus, my concern with respect to legislative proposals to conduct wide-scale surveillance of the physical and OTC derivatives markets in natural gas is that they may represent more of a political response to high energy prices than a practical attempt to identify manipulative behavior in the markets.
But that is not to say that we should not be vigilant with respect to market manipulation or that we cannot today identify market abuses and go after it. Many of you are aware that the CFTC has gone after a number of companies and individuals for reporting fake transactions or intentionally misreporting transaction prices for the purpose of affecting market indexes. The behavior was wrong and needed to be stopped because nothing can kill off a market more quickly than the belief that the market is unfair. The Commission will continue to monitor the natural gas markets and pursue wrongdoing where we have the authority to do so.
In summary, I believe that we must have confidence in markets and the price signals they send out. Just like the tail on a dog, price signals tell us something vitally important about the underlying markets. The tail tells us when the dog is happy or when it is angry. This is important information when we are deciding whether to pet him or stay away for fear he may bite.
Similarly, price signals tell us when it is okay to consume more of a commodity or to conserve in its use. They tell us when it is wise to invest in more production or to invest in other projects. Sometimes as consumers we do not like the price signal we see, but if we chose to ignore it, the long-term consequences can be even more severe.
I would be happy to entertain your questions regarding the CFTC, pending legislation, and the natural gas markets in general.
Last Updated: April 18, 2007