Part Four: The Regulators Blowtorch Oil Speculators

With gas prices possibly careening toward $7 a gallon, with plans afoot to have cars drive and airplanes fly on hooch, with the Central Bank of Oil, Saudi Arabia, pumping more sour than sweet crude (striking fear that it really may be running out), oil speculators are in the bulls' eye in this tumultuous political season, when the haymaker of inflation has chopped through family budgets, when the subprime crisis has gone viral around the world, a credit crunch sans frontieres.

Congress is now igniting a stink bomb under the oil markets, leaving me to wonder when the European Union is going to file an antitrust action against OPEC instead of hectoring Microsoft into a nervous breakdown, which likely won't happen as Europe needs the energy tank that is OPEC (and Iran's nuclear energy too?) given that a quarter of its oil and gas comes from an increasingly erratic and undependable Russia.

But all this is for another day. On top of the agenda is the move by lawmakers to shut the London loophole which allows oil trades offshore, a loophole born out of the criminal enterprise that was Enron.

About a dozen pieces of legislation of different stripes and colors are before Congress, all built on the foundation that speculators have caused oil prices to soar, as oil prices have soared higher since last summer, just about when the Federal Reserve started to open a gusher of liquidity in the form of interest rate cuts and term liquidity auctions to repair a damaged Wall Street, causing the dollar to drop in value.

Oil traders are in the crosshairs, and it's certainly true that the free market has turned into a free for all here. Oil speculators are to blame--but no one under this sun in this galaxy in this place and time can offer proof positive just how much in dollars and cents they have caused oil prices to spike.

One plank in the oil speculator argument is the idea that commodities index funds have exploded in value, according to Barclays Capital, an investment bank, to $225 bn in the first quarter, though that blithely ignores the fact that these commodity assets under management include trades in metals and agricultural investments, too.

Barclays said assets climbed by $28 bn in the first quarter, almost three times the gain in the same year-earlier period. How much that $28 bn translates into what dollar price of the now $144 a barrel is anyone's best guess in a world that sees trillions of dollars in commodities traded daily.

And Barclays Capital, an investment bank, says that the rise in commodity index funds, the very same funds which have agitated Congress because they remain bullish on oil and ipso facto have caused oil prices to rise, in the first quarter grew by just $13bn from the prior period.

Only $2 bn represented net inflows, Barclays says, with the rest, $11 bn representing the effect of higher prices, meaning, appreciation, meaning, a weak dollar.

Speculation in oil, Barclays says, has been flat lining and speculative money is moving toward the short side. On that score, the latest count of crude futures shows 216.4 mn barrels in long positions and 188.1 mn in short positions.

In other words, Barclays Capital calculates that index funds amounted to just 12% of the outstanding contracts on the New York Mercantile Exchange (NYMEX), with a value equal to a teensy 2% of the world's yearly oil consumption.

Go figure. Never mind that no physical barrel of oil is sold or removed on these markets, that instead these are paper barrels, these are essentially bets on the direction of oil prices, with deals settled in cash not physical barrels of oil. Oil traders make bets on expectations of supply and demand.

The logic here is that if oil traders really do jack up oil prices to ridiculous levels, then consumers would flee, demand would plummet, and oil fields would sit abandoned. You think that's really happening?

However, two professors from Hofstra University say that while short-term contract supply problems can whipsaw oil prices, but when it comes to long-term futures contracts that last longer than a year, now get this, "there is empirical evidence of hoarding in the crude oil market: both oil stocks/inventories and futures prices are found to be positively cointegrated/correlated with each other."

Message here: Both hoarding and long term bets can potentially hurt oil prices down the road. Think of China's Beijing Olympics, given that the country is scrambling to stop pollution, so it's dumping coal for now, and also the fact that it wants to save face and not have any embarrassing oil shortages whatsoever as the world comes crowding in to the Middle Kingdom this summer.

So, speculators are behind some unknown amount of oil price increases. The real pivot of this affair is stopping some whacked out greedy trader from whipsawing the market. Huge commodities bets have jerked the market around in the past--think Enron and the hedge fund Amaranth Advisors flame-outs. The fear is legitimate that these bets could wreck it for consumers, but you don't hear that nuance out of Congress.

Back to the regulatory problem on oil trading, which is really an oversight problem that has bedeviled the markets for decades.

Here's the issue. Credit swaps in oil, swaps that are not traded on regulated exchanges, usually are made by huge institutional investors like pension funds and hedge funds. They are now estimated to be at $260 bn, up from less than $6 billion ten years ago. These trades sit outside the regulatory radar. A Congressional committee that is looking into these trades released data back in June that says only 15% of index investing is transacted on regulated futures exchanges, with the rest off line, out of sight of the regulators.

However, the Enron loophole did not first create the problem of unregulated paper barrels of oil. According to a recent Congressional committee hearing on oil speculation, the CFTC authorized its first exemption from position limits for swap dealers with no physical commodity exposure way back in 1991. The move let investment banks start to build massive trades in commodity markets. Paper oil barrels have in turn been in the market for about 17 years.

Bureaucratic apathy then got a high level blessing back in 1993, when Wendy Gramm, then head of the Commodity Futures Trading Commission and wife to former Sen. Phil Gramm, ushered in a rule change that let these swaps avoid CFTC regulation.

Enron then built an electronic platform for trading energy futures, called Enron Online, in the late ‘90s.

Then the Enron loophole was enacted when the Commodity Futures Modernization Act passed in 2000 after lobbying by the infamous Houston energy company. The legislation exempted electronic energy exchanges from much federal regulatory oversight and exempted these swaps from regulation.

The legislative change essentially let large firms trade energy commodities on over-the-counter electronic exchanges exempted from the CFTC. The Enron loophole was engineered by then-Sen. Gramm (R., Tex.), among others Congressmen.

With the legislative change in 2000, paid for with lobbying dollars by Enron, the majority of energy trading drifted from the regulated NYMEX to the more loosely regulated London's InterContinentalExchange (ICE), the over-the-counter energy-trading venue which also runs the ICE Futures Europe platform.

Then in 1999, the London exchange obtained the CFTC's permission to install computer terminals in the United States to let traders in New York and other US cities trade European energy commodities through the ICE exchange. Previously, the ICE Futures exchange in London had traded only in European energy commodities.

Flash forward to January 2006. The Bush administration's CFTC then let the ICE use its trading terminals in the United States to trade US crude oil futures on the ICE futures exchange in London, according to a recent report.

So that's how the Enron loophole morphed into the London Loophole, now to blame for the runaway freight train packed with oil speculators that is mowing down consumers and companies alike.

Here's the problem as it stands today.

NYMEX traders must keep records of all trades and report large trades to the CFTC, along with daily trading data noting price and volume information. The CFTC uses that data to track speculation and price manipulation, reports indicate.

But traders on unregulated OTC electronic exchanges don't have to keep records or file these "Large Trader Reports" with the CFTC, and these trades are exempt from routine CFTC oversight, reports indicate.

Also, there is no limit on the number of contracts a speculator may hold on an unregulated OTC electronic exchange, no monitoring of trading by the exchange itself, and no reporting of the amount of outstanding contracts ("open interest") at the end of each day, reports note.

Under current law, US traders can execute mirror transactions in what are called look-alike contracts in crude oil contracts on both the NYMEX and on London's ICE. Futures look-alike contracts are traded in loosely regulated markets, while oil futures contracts are traded on regulated exchanges.

The problem is, US regulators have an eye only on what goes on in New York. CFTC regulators don't have a complete picture of trading activity in order to ensure manipulation is not occurring. The reason is, US law restricts regulation of "foreign boards of trade by domestic regulatory bodies," notes Bart Chilton, a CFTC commissioner, adding the proposed US legislation would close this gap.

Traders can arbitrage between the two markets, and the CFTC in effect regulates only half of the trading, Chilton says. ICE is not required to be self-regulated, as the NYMEX is, and it is not regulated by the CFTC. Instead, the ICE is regulated by the United Kingdom's regulator, the Financial Services Authority in London, which, for instance, does not establish position limits, as the CFTC does.

While critics say this arbitrage has caused a record rise in oil and gas prices, leaving parts of the market vulnerable to manipulation and excessive speculation, the debate now is based on, well, speculation, because no one really knows.

However, fresh new legislation and the CFTC's crackdown are "intended to close a significant regulatory lacuna in the CFTC's commodities market surveillance system," explains Chilton.

The new legislation will require electronic energy traders to provide an audit trail and record-keeping of their trades, provide a [hallway] monitor for market manipulation, significantly increase financial penalties for cases of market manipulation and excessive speculation, require the CFTC to get big hedge funds and other "large traders" to report their biggest positions to it, plus force traders exceeding position limits on the market to cut their holdings.

Proposals are flying around too that would force higher margins in commodity trades, and would dramatically increase the collateral required to make a trade.

The thinking is, if federal regulators could have seen Enron's corrupt electricity trading, and the hedge fund Amaranth Advisors' equally corrupt gas trades in 2005, bureaucrats could have stopped Enron's gouging of consumers in California with trades that artificially whipsawed electricity costs higher and caused rolling blackouts in the state.

And grey office beavers could have stopped Amaranth from gouging consumers in Georgia with bets that caused higher gas prices in this state. This doomed hedge fund moved contracts to London to pile up excessive natural gas positions, bets which ultimately went south and caused the firm to flop, the largest hedge fund failure at the time with $6 bn in investor losses

Yes and government bureaucrats can stop solar flares and Mars from wobbling to help prevent global warming, and El Nino is caused by the First Lady's smoking. Didn't you know that?

More regulation is needed to stop greedy oil speculators, but we can only hold hands and pray that a well-meaning bureaucrat can stop speculators from cornering a market.

This boils down to the issue of transparency in oil trades, a weak dollar, and supply and demand.

Oil trades have picked up speed due to a plummeting dollar. Notably pension funds have piled in, as they are required to protect their pensioners against price increases by seeking high returns that beat inflation, so they've migrated away from depreciating bonds and into the oil market.

As the Federal Reserve cut interest rates, the treasury bonds that are usually the preferred investment vehicle of choice for pension funds and endowments no longer could keep pace with inflation so they plowed into oil.

Will new regulation have an impact? Stay tuned.