Municipalities Demand More Regulation of Energy Trading

Free market fundamentalists, most of which have never been within hailing distance of a real market (save perhaps a ceremonial visit to the New York Stock Exchange) view market prices as virtuous and seem woefully ignorant of the games speculators and market-makers play (see our post, “Are Speculators Driving Energy Prices?“)

An article in the Finacial Times, “Flame blame: how traders distort may distort energy costs,” discusses how US municipalities are pushing for greater transparency in US energy trading markets. As energy prices and policies become more politicized, it appears likely that collective interests will collide more forceably with institutional profits. And the same conflict is likely to affect carbon trading markets as they develop.

In a letter to Congress, the two [public utilities associations] warned that a lack of regulatory oversight in the vast over-the-counter energy trading markets meant that the prices consumers paid for the gas to heat their homes might be vulnerable to “manipulation strategies” by traders speculating in these sophisticated markets in New York and London.

“Over-the-counter” markets have become a powerful feature of the way energy is traded globally – anything from petrol and petroleum futures or natural gas and gas futures to more complex derivatives such as energy swaps. Unlike on the New York Mercantile Exchange, the world’s biggest market for oil and natural gas, OTC trading is not conducted in a pit where traders shout orders back and forth and the exchange reports their trades to the Commodity Futures Trading Commission (CFTC), the US regulator empowered to oversee on-exchange energy futures.

Instead, participants anywhere in the world negotiate specially tailored contracts with each other – linked by a telephone or computer screen connected to a special platform such as the Intercontinental Exchange, which operates a rapidly growing electronic crude oil futures trading business out of London.

Such ventures…account for up to 75 per cent of energy trading in the US…. But – to the alarm of the Iowa utility group and others – OTC markets have been only lightly regulated since their emergence as a force in energy dealings. Regular exchanges such as Nymex are fully regulated….

Manipulation typically occurs when traders drive prices up or down, beyond the normal forces of supply and demand – by either buying or selling unusually large amounts of the commodity in question…

OTC markets have not only grown rapidly in the last five years but their size also means they provide a “price discovery” function – that is, participants in the exchange-traded markets increasingly look to OTC prices to signal pricing direction for their trades. Tony Mansfield, former chief trial attorney in the CFTC’s enforcement unit and now with the law firm Heller Ehrman, says: “It’s increasingly difficult to expect that you can understand the on-exchange market if you are not taking time to pay attention to the off-exchange market. Trading strategies incorporate both markets.”

Despite the new importance of OTC markets, the CFTC has very limited powers to monitor these trades….OTC energy markets were exempted from such oversight by passage of the Commodity Futures Modernisation Act in 2000…Critics call this the “Enron loophole”.

Now, with Democrats in control of both houses of Congress, there is a clamour to close the loophole by requiring traders in the OTC markets to provide regular reports to the CFTC….

Dianne Feinstein, a Democratic senator from California who has campaigned on the issue since before 2000…has proposed a bill that would require traders to keep records on platforms such as ICE for five years and send regular trading reports – known as “large trader reporting” – to the CFTC. Last week Bart Stupak, a Democratic colleague of hers, introduced a similar bill in the House of Representatives.

But can attempts to close the Enron loophole succeed this time, where previous efforts by Senator Feinstein have repeatedly failed? The first problem is that that no one has yet proved conclusively that there is a link between speculation in the OTC markets and the prices that consumers pay for energy – although three studies have come close….

A second obstacle is the old Enron lobby itself….They have been diligent in wooing both Republicans and key Democrats who are perceived as being keen to keep Wall Street happy….

Some also warn that even if a way could be found of forcing OTC traders to institute reporting – difficult in the large phone-brokered segment of the market – this could drive markets away from the US….

Critics still say that without a regular monitoring role, the CFTC’s powers are limited. Indeed, the CFTC would not have been able to pursue many of the 35 energy-related trading cases it has filed since 2002 had it not been for tip-offs from marketparticipants. Randall Dodd, director of the Financial Policy Forum, a Washington-based non-profit financial research institute, says: “It’s dishonest for the government to say they have a full picture of what’s going on, because they don’t know the extent of activity and there’s no way they can know.”

Regulators are privately concerned that a source of price manipulation may also lie with the companies that control oil and natural gas supply at the scores of hubs scattered across the US….The CFTC is already investigating one Texas-based pipeline operator, Energy Transfer Partners, after reports that a subsidiary artificially lowered the price of natural gas at a gas purchasing hub in an apparent attempt to influence the prices reported to a widely-used gas index publication. That in turn allegedly influenced the outcome of a series of swaps trades on ICE…

Asked whether OTC activity could influence consumer prices, Roger Cooper, vice-president of policy at the American Gas Association, another advocate for local natural gas utilities, says: “The answer is no one knows. Is it possible that all this [hedge fund] money flowing in tends to push up prices a little higher then they would be in illiquid markets? Yes, it is possible.”

But, in the absence of any proof, he adds: “If people raise this question, then we have to have more transparency – if for no other reason than to reduce this uncertainty.”

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