Oil's rise helped by loopholes

The Star-Ledger, July 6th, 2008

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Date: 2008/07/06 Sunday Page: 001 Section: BUSINESS Edition: FINAL Size: 1810 words

Crude, other commodities now easier to manipulate


ICE. Dark markets. The Enron loophole. Swap dealers. The London-Dubai loophole. No-action letters. These are not words that roll off your tongue when you fill up your car with $4-a-gallon gas.

But they should be.

Testimony from nearly 40 congressional hearings held so far this year shows investors, such as hedge funds and investment banking firms, are using loopholes in commodities laws to manipulate the market and drive crude oil, heating oil, gasoline and diesel fuel prices to new heights. Just last week, oil surpassed $145 a barrel for the first time.

"Money goes wherever it is invited, and it has been invited into the commodities market by lax regulations," said Mark Cooper, director of research at the Consumer Federation of America.

The exact role speculative trading is having on soaring oil prices remains a topic of hot debate. But one oil analyst said deregulation of the commodities markets since 2000 has created "the world's largest gambling hall."

"It's open 24/7," said Fadel Gheit, a senior oil analyst at Oppenheimer, the Wall Street securities firm. "Unfortunately, it is totally unregulated. This is like a highway with no cops and no speed limits, and everybody is going 120 miles an hour."

So far, lawmakers have introduced nine different bills designed to tackle escalating fuel prices and limit or ban speculators from the markets that could ultimately transform how oil is traded, affecting everyone from Wall Street investment banks to consumers at the gas pump.


It happened one day in Washington, just before the 2000 Christmas recess, said Michael Greenberger, a professor at the University of Maryland and a former board member of the Commodities Futures Trading Commission.

A 242-page bill drafted by Enron lobbyists and co-sponsored by Texas Sen. Phil Gramm – then chairman of the Senate Finance Committee – was inserted into an 11,000-page appropriations bill without the benefit of a floor debate or any hearings, Greenberger said.

The effect of the Commodities Futures Modernization Act of 2000 has been far-reaching.

Before this law, trading of oil futures and other commodities in the United States was limited to exchanges such as the New York Mercantile Exchange, or Nymex, which are regulated by the Commodities Futures Trading Commission to guard against price manipulation.

Futures are contracts where one party agrees to buy or sell a certain commodity, such as a barrel of oil, at a certain price at an agreed-upon date in the future.

One of the primary functions of the futures market is to provide "price discovery" in the spot market – where buyers and sellers actually trade those commodities in real time. Those selling or buying commodities in the spot markets rely on futures prices to judge how much they should charge or how much they should pay for the delivery of a commodity, Greenberger said.

The new law permitted large professional traders to, for the first time, bypass these regulated exchanges if they traded energy commodities, such as oil or natural gas, on over-the-counter, electronic markets.

As a general rule, exchanges like Nymex place strict limits on how many futures or options contracts investors are permitted to hold at any given time – a restriction designed to prevent anyone from cornering the market on a particular commodity.

But electronic, or so-called "dark," markets don't have any limits, said Thomas LaSala, the chief regulatory officer at Nymex, the largest energy market in the world.

This allows large investors and billion-dollar hedge funds to go on these so-called unregulated "dark markets" and buy unlimited quantities of energy contracts without being subject to any statutory or regulatory requirements

In addition, electronic exchanges are not required to file "Large Trader Reports" – which CFTC chairman Walter Lukken described during a recent Senate testimony as "the backbone of our market surveillance program." (The CFTC did not respond to repeated requests for an interview.)

These reports require large traders to file daily reports with regulators detailing all their trading activities. Without this data at their fingertips, Greenberger said regulators have no way of gauging the extent of speculation on electronic markets, limiting their ability to detect price manipulation.

"The absence of large trader information from the electronic exchanges makes it more difficult for the CFTC to monitor speculative activity and to detect and prevent price manipulation," a 2006 Senate subcommittee report said.

The first beneficiary of the 2000 law was the Houston energy giant Enron, which used these dark markets to drive the price of electricity up almost 300 percent for California consumers back in 2000, Greenberger said.


Around the time of Enron's collapse in 2001, another unregulated electronic market emerged. This one was called the Intercontinental Exchange, or ICE.

The founders of the Atlanta-based exchange included a mix of Wall Street firms and oil companies, such as Morgan Stanley, Goldman Sachs, British Petroleum, Deutsche Bank and Royal Dutch Shell, and it was headquartered in Atlanta. Because ICE was an all-electronic exchange, it, too, was deemed an "exempt commercial market," Greenberger said.

To understand how large investors can game the system using the disparities between the regulated and unregulated markets, consider the case of a Greenwich, Conn.-based hedge fund called Amaranth Advisors, which collapsed in September 2006, after losing more than $6 billion on bad bets on natural gas trading. A civil case against the firm and trader Brian Hunter is pending.

LaSala, the Nymex regulator, said the exchange grew concerned about the size of Amaranth's holdings early on and asked the fund to liquidate its position. Amaranth opted to leave the Nymex and place its massive bets on ICE, LaSala said.

"They created an out," he said of electronic markets such as ICE. "If you bang into limits or LaSala asks you too many questions and it becomes a hassle, you can go through another exchange, where the standards are far lower. It's become a joke."


In 2001, ICE purchased the International Petroleum Exchange in London, turned it into an all-electronic exchange and renamed it ICE Futures Europe. At the time, it traded only in European commodities – Brent crude oil and United Kingdom natural gas.

It, too, was granted a regulatory pass by the CFTC, experts said, thanks to another administrative loophole that allows foreign exchanges to trade U.S. oil, gasoline and heating oil futures contracts without any direct U.S. regulatory supervision.

Essentially, ICE Futures Europe is overseen by U.K. regulators, even though the exchange is owned by a U.S. company and all its trades are settled in dollars.

In January 2006, CFTC regulators allowed ICE Futures Europe to start trading a futures contract for West Texas Intermediate, or WTI, crude oil, a type of crude oil that is produced and delivered only in the United States. Up until that point, the WTI crude-oil contracts traded exclusively on the regulated Nymex exchange.

This rule meant traders within the United States who wanted to trade certain U.S. energy commodities could now avoid all U.S. market oversight or reporting requirements by routing their trades through the ICE Futures exchange in London instead of the Nymex in New York, LaSala said.

Today, Greenberger said up to 30 percent of trading in West Texas Intermediate crude-oil futures has shifted to "dark markets" and are completely unregulated.

Under political pressure, the CFTC told a Senate panel on May 29 it would start collecting daily trading data for all U.S. oil contracts traded in London from British regulators. The trading commission also said British regulators would now notify them whenever traders exceeded speculation limits that apply to oil contracts traded in New York.

But such trading isn't limited to London. Over the years, the CFTC has exempted itself from regulating a variety of contracts in 16 other foreign exchanges.

In May 2007, regulators allowed the Dubai Mercantile Exchange to install trading terminals in the United States, but be regulated by the Dubai Financial Services Authority. On May 16, the Dubai exchange announced that, in partnership with Nymex, it had received CFTC approval to begin trading WTI contracts as well.


Historically, regulators and exchanges have imposed limits on how much of any given commodity can be traded by so-called "non-commercial" players – speculators who buy futures to bet on price movements, but who never intend to take physical possession of the actual commodity.

"Commercial hedgers," on the other hand, like farmers or food processors or anyone else directly involved in the food or energy chain, have always been free to trade unlimited amounts to manage their risk and run their business.

The size and position limits the CFTC places on speculators are designed to prevent manipulation and distortion, experts said.

But in its push to deregulate the markets, the CFTC reclassified investment banks such as Goldman Sachs and Morgan Stanley as "commercial hedgers," when these banks hedge over-the-counter swap transactions.

In other words, they are not subject to any limitations on the size of the positions they can take when it comes to commodities. And they don't have to file the daily reports that enable regulators to monitor all traders of size to ensure no one is manipulating the futures markets.

"The real shocking thing about this loophole is that speculators of all stripes can use to access the futures market," said Michael Masters, president of Masters Capital, a hedge fund in St. Croix, Virgin Islands, who has testified at congressional hearings.

He said this has helped fuel the boom in commodities trading. Money flowing into commodity index trading strategies has risen to $260 billion as of March 2008, from $13 billion at the end of 2003.

At the same time, the prices of the 25 commodities that comprise these indices have risen an average of 183 percent in those same five years.

Last month, the CFTC said it plans to gather more detailed data from swap dealers on the amount of index trading in the markets and to examine whether these traders are classified correctly. The CFTC said it will provide a report highlighting its findings to Congress on Sept. 15.

Sam Ali may be reached at sali@starledger.com.

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