US unveils energy futures limits

The top US futures market regulator unveiled its long-awaited proposal to crack down on speculation in oil and gas markets today, but set position limits so high that they would affect only a handful of the biggest players, bringing some relief to edgy traders.
In an effort to prevent excessive concentration by setting a cap on the number of contracts that a company can hold, the Commodity Futures Trading Commission issued a package of proposals that was generally less stringent than expected, including an exemption for swap dealers -- typically big banks -- to hedge financial risks up to twice the usual limit.

"It doesn't look like there will be that many entities affected by it. In some respects, I don't think it will have that big an impact, certainly immediately," Craig Pirrong, professor of finance at the University of Houston, said.
For instance, the limit on crude oil would equate to a 98 mm barrel position -- equal to more than a day's global consumption, or near $ 8 bn today -- and is five times the New York Mercantile Exchange's own loosely enforced cap, which may assuage fears that tough limits would cause an exodus of liquidity to overseas or unregulated markets. However, as part of the Obama administration's push to overhaul financial markets, the CFTC must now explain its softer approach to lawmakers who have clamoured for regulatory action since oil prices surged to a record $ 147 in 2008.

Oil prices briefly edged slightly higher after the news, although some analysts said they feared even the modest start could be enough to encourage trade to seek out other jurisdictions like the UK, where regulators say they do not see position limits as the way to tame manipulation and volatility.
"The energy markets are breathing a sigh of relief that the CFTC proposals on position limits do not seem as bad as feared," Phil Flynn, analyst with PFGBest Research, said. The limits, which are now open to 90 days of public comment, will apply to futures and options contracts of light, sweet crude oil, RBOB New York harbour gasoline and Number 2 heating oil futures traded on the Nymex; it will apply to Henry Hub natural gas contracts on both the Nymex, owned by the CME, and the Intercontinental Exchange (ICE).

In brief, the limit for the entire asset would be set annually based on open interest at the sum of 10 % of the first 25,000 contracts plus 2.5 % of the remaining interest, allowing a regular annual adjustment to the limits rather than the fixed caps the CFTC applies to grain markets. It said the limits, if implemented, would affect the 10 biggest position holders in all markets.
Over the past two years, only three "unique owners" in the crude oil market and only one in the natural gas market would have been affected, according to Steve Sherrod, acting director of surveillance at the CFTC. Exemptions will continue to be granted by the exchanges to bone fide hedgers who need to hedge their physical positions, while the CFTC will be responsible for granting "risk management" exemptions to swap dealers at a maximum of two times the otherwise applicable position limit.

But it said the limits should help prevent out-sized players from becoming a risk to the whole market. For example, the CFTC said under the limits, the giant hedge fund Amaranth would not have been able to hold the large number of natural gas contracts it did in 2006, which led to the fund's collapse with ripples felt across markets.
"Certainly, some of those with size to move the market around will find it difficult to operate as usual," Chris Jarvis, senior analyst with Caprock Risk Management, said. But they did not appear strenuous: A CFTC official said that if the rules were applied today, for example, the limit for NYMEX crude oil contracts across all months would be 98,100 contracts. The Nymex's own so-called "accountability levels", which were frequently exceeded, is 20,000 contracts across all months.

And investors had questions about how the CFTC might get a grip on the vast over-the-counter energy markets and what it would do about the influx of passive, long-term investors who buy and hold positions via index funds.
"The fact that we have a whole class of traders that only buys and holds what they don't need distorts the market and needs to be addressed," Peter Beutel, president of Cameron Hanover, said. It appeared likely to be just the start, as the CFTC said it would seek public comments on whether the other commodities like metals, coffee, sugar and cocoa should be subject to similar position limits, and hold a meeting in March to focus on silver and gold markets.

The proposal is the first major regulatory reform for the CFTC since Gary Gensler, a former Goldman Sachs executive, became chairman in May with promises to get tough on the volatile world of commodity trading. His actions parallel reforms pending in Congress and dovetail with the Obama administration's proposals to bring over-the-counter derivatives under federal regulation.
Until recently, the once-staid agency was faulted for its hands-off approach. Lawmakers criticised CFTC for not doing enough to tamp down the influx of hot money from hedge funds.

There has been intense debate among analysts whether excessive speculation and big money inflows were responsible for the wild swing in energy prices in 2008. But efforts to tighten positions limits have drawn their fair share of critics. The ICE and the Chicago Mercantile Exchange, the world's largest exchange which owns the Nymex, have urged the CFTC to be cautious.
Opponents say limits could actually make markets more volatile, distort pricing functions and push traders to less-regulated offshore markets. The UK's Financial Services Authority recently issued its own plan for overhauling OTC markets, which sharply contrasted with European Union and US plans. The FSA said while it supported preventing manipulation, position limits were not the most effective way to curb manipulation and volatile prices.

Commodity traders have been bracing for tougher trading limits since the CFTC announced in July it was going to review setting limits for commodities of finite supply, but the actual impact of new regulations may be difficult to gauge.
Several large exchange-traded funds have been forced to suspend share issuance or adjust their strategies to appease regulators, while some major players are working out ways to shift toward trading of physical commodities.