A U.S. Senate report issued two weeks ago on the Amaranth meltdown makes three recommendations which call for greater oversight of energy markets. It wants Congress to eliminate the "Enron loophole" to give the Commodity Futures Trading Commission (CFTC) regulatory power over both the NYMEX and ICE (electronic, over-the-counter exchanges), allow the CFTC to monitor aggregate positions on both exchanges, and raise the CFTC's budget authorizing them to collect fees to offset the cost of the additional oversight. The Senate report, while not actually accusing the hedge fund of any price manipulation, criticized "excessive speculation" which (in its opinion) altered natural gas markets causing increased volatility and impacting consumer prices. Amaranth at one point held 70 percent or more of the outstanding contracts on the NYMEX and when told to reduce that position, it did so but then increased its holdings on the ICE instead.

The U.S. Senate report follows the FSA report in March this year in which they warned about the increasing risks in commodity investing. To briefly summarize their findings, the FSA warned that there was insufficient energy experience at many investment firms and that the existing experience is overstretched. Furthermore, they said that increased volatility in many commodity markets raised the "cost of trading and the risk of financial failure" and promoted the concept of proper risk management including "thorough testing and modeling for algorithmic trading systems." But they went further in recognizing that many investment firms are now investing in commodities through physical assets (i.e., holding and trading physical position) such that their portfolios are "significantly altered and risk management systems must be appropriate and senior management must fully appreciate the risks they are assuming." Lastly, the FSA stated that "consumers' risks are being exposed to unsuitable investments that they do not fully understand."

Speculative Forces

For a long period of time, it was impossible to read a news article without reading about speculators in energy markets forcing up prices and of a "speculative premium" in energy prices. It's a sensitive and polarizing issue. The problem is that there are two sides to this argument and both hold valid concerns but, in the main, neither seems to really understand how energy markets work (i.e., they are not energy experts but politicians and groups with a preset agenda) and there is a paucity of hard data to back either point of view. In the end, I take the view that increased oversight and regulation will occur because politicians need to be seen doing something—anything—to protect the little man.

To me, the truth of speculation in energy markets and the impact on prices appears to lie somewhere in between both camps (those that say it has no impact versus those that say it does). You see, I am a Ph.D. geologist and the history of geological theory is full of polarized viewpoints that eventually merged to common ground including the past held views that all rocks were sedimentary or igneous! To say that "speculative" trading in energy markets has no impact on price formation must surely be false but to say that it is responsible for today's high prices is also surely false.

What ultimately drives price formation are the fundamentals—supply/demand, weather, logistical issues, and so forth. Overlying the fundamentals are market rumor and innuendo including geopolitics and terrorism—essentially this is a market view on forward risk to supply disruption. Over the last several years the fundamentals have been signaling higher prices —on that I think most people are agreed—but the question is how much higher should prices be? And, what proportion of the price is "speculative"? Over the last two to three years, there have been some breakdowns in historical price trends (heating oil over gasoline and so on); there has certainly been greater absolute price volatility. To me, this suggests that from time-to-time the consensus market view of supply disruption risks has been overstated. Is this speculation?

Supply and Demand

The first factor to consider is supply and demand. There can be no doubt that all energy and energy-related commodities are deemed to be in short supply either regionally or globally. The rapid economic growth in China and India coupled with insatiable demand in North America has meant that after an elongated period of under investment in energy infrastructure, supply and demand are more tightly coupled. It is this factor that has naturally supported price rises in energy commodities1. As prices rose, investors placed directional bets gaming the industry (which was working with older and lower price forecasts as it turned out). It is still the fundamentals of supply and demand (and the inter-related factors of weather, supply disruption and so on) that mostly drive prices today. For many energy commodities, prices have now become quite volatile within certain price ranges and investor's strategies have switched in the main to spread trading.

Reduced Barriers to Entry

The barrier and cost to entry into energy commodity trading have come down considerably in the same time frame. It is no longer the exclusive club it used to be—but that is a good thing! I can trade commodities in my IRA portfolio these days. Markets are also a bit more transparent—it is no secret that almost everyone knew about Amaranth's natural gas positions and rumors were rife about their positions and how the fund would lose money at that time. For me, what seems to be happening is that many more firms and individuals are "playing" the market these days and many of them do not understand energy. They watch for price signals and movements and they follow like a herd. It's easier to do now because the markets are more transparent. This is one facet as to why volatility is higher—prices have a tendency to move too far in one direction or the other. As a result, I believe there is a "speculative" premium from time to time in energy markets but it is neither a permanent feature nor is it necessarily large. It is the overall behavior of prices that are impacted and we know good energy traders who have quit the markets after 20+ years of trading because "they don't understand what is going on with price formation anymore."

The Real Impact of Speculation

The real impact of increased "speculative" trading has been, in my opinion, overwhelmingly positive. It has increased liquidity, increased the type and nature of trading instruments, allowed greater transparency and it has established, in the main, a better market value for the these incredibly precious and finite commodities driving increased interest and investment in alternative fuels. I would also go so far as to argue that it has allowed energy prices to reflect their true value in turn increasing interest in alternative energy and efficiency.

No Rush to Judgment

Energy markets are rapidly maturing but with the barrier and cost to entry falling, it may well be time for some well considered discussion about increased oversight of energy markets. The markets have changed and a review of the checks and balances is prudent if it is done responsibly. It seems to me that there are too many other agendas at play to ensure that this can take place, and poorly thought through regulation or oversights as a result of ill considered analysis could inflict significant damage on these maturing markets. There should be no rush to judgment based on the perception of pressure groups and lobbyists but a carefully considered review by those that understand how this industry works would be prudent.

Summary

The two polarized views originate from those with agendas. On the one hand higher energy prices have tremendous economic and social implications and if there is a persistent speculative premium then how and why this is occurring needs to be understood. On the other hand there are those who see any potential investigation as a potential threat to these maturing markets and they are quick to point out that past efforts to regulate markets more effectively have been ill considered, reactive and essentially resulted in damage to markets. They both hold valuable opinions.

It seems to me that a rapidly maturing and growing market in which the barrier to entry has fallen considerably ought to be reviewed on a continuous basis not because prices have risen but because the markets have fundamentally changed in character. Are the small investors adequately protected and educated as to the risks that they bear? Can the market be more easily manipulated even over short periods by large investors? Are adequate controls in place?

Again, I would suggest that the complexity of the energy industry is poorly understood. Skills have and continue to leave the industry through retirement and for many years no one wanted a career in energy. If more oversight is required, let's make sure that the review and the decisions are made by those that understand this industry.

1 For a thorough analysis of supply and demand across energy commodities see Energy and Environmental Hedge Funds - The New Investment Paradigm by Fusaro & Vasey (Wiley, 2006)