Limits on Energy Derivatives—Does CFTC’s Rationale Fit?

What is the rationale for regulation?

That is a question that comes to mind—or that should come to mind—whenever a regulator issues a major new rulemaking, as the Commodity Futures Trading Commission has done with rules to limit trading in energy derivatives, rules that promise to impose significant costs and burdens on those who participate in the energy markets.

In a long-awaited action, the CFTC, on Oct. 15, finalized rules to impose federal position limits on a number of physical commodities, including those relating to agriculture, energy, and metals.

The 899-page final rules and rule release adopted on a 3-2 party vote, culminated a 10-year effort by the agency to carry out a congressional mandate requiring limits as part of the Dodd-Frank Act. While the CFTC’s action is less burdensome in many respects from previous proposals, the action nevertheless suffers from a number of analytical shortcomings relating to its purpose.

Not the least of these shortcomings is the lack of a compelling rationale for taking such action, and the dearth of empirical evidence to support it. They are especially conspicuous with respect to the limits that are being imposed for the first time at the federal level on the energy sector, i.e., oil and natural gas.

A Flawed Premise, Little Evidence

Historically, position limits were mandated for only a handful of agricultural commodities in order to curb or prevent “sudden or unreasonable fluctuations” or “unwarranted changes” in the prices of such goods. The CFTC action extends that mandate to oil and gas, as one account explains, in order “to set position limits in response to lawmakers’ belief that speculators had caused a sharp increase in oil prices.”

But that premise—that speculation in energy derivatives by traders, swap dealers and passive index funds is responsible for the rapid rise of the price of oil and natural gas that occurred during the first decade of the millennium—has never been supported by empirical evidence. To the contrary, the CFTC’s own economists consistently found speculation not to be a problem in these markets.

For example, during the height of the supposed speculative-induced price frenzy in energy in 2008, the CFTC’s chief economist soberly testified before Congress that there was “little evidence that changes in speculative positions [were] systematically driving up crude oil prices.”

This testimony was corroborated by a report issued by the Interagency Task Force on Commodity Markets led by the CFTC that found—counterintuitively—that oil prices rose inversely to speculative activity in energy derivatives.

Further, it found that there was “no statistically significant evidence that the position changes of any category ... of traders systematically affect prices,” and that far from driving prices higher, speculators likely “provided a buffer against volatility-inducing shocks.”

The task force also took issue with the notion that financial investors had pushed prices above fundamental values, stating that this view was “difficult to square with the fact that prices for other commodities that do not trade on established futures markets (such as coal, steel, and onions) ha[d] risen sharply as well.”

Likewise, in 2016, a CFTC committee established to advise it on such issues, the Energy and Environmental Markets Advisory Committee (EEMAC), observed that there was “little to no evidence” that position limits in the energy markets were necessary, and that imposing such limits on the energy markets amounted to “a solution to a nonexistent problem.”

Experience since then has borne this out with the energy sector plagued by what one former CFTC chair described as ”value destruction” caused by rising output and persistent decline in oil and gas prices, a state of affairs completely opposite of what one would expect if speculators were in control.

Indeed, one news item summed it up best when it asked: “Where Have All the Oil ‘Speculators’ Gone?” Given all this, one wonders whether the prudent action would be to encourage more, rather than less speculation in these markets.

The Exchanges Are Better Suited to Regulate

Even if we assume that position limits are necessary, that still leaves open the question why such limits should be imposed by the government, rather than by the exchanges, who for years have administered their own limits for energy contracts.

In general, it is well recognized that exchanges are in a much better position than a government regulator to set the level of such limits, apply them to where they are really needed, tailor them to the economic characteristics of each contract, and adjust them in a timely manner as economic conditions change. As the CFTC’s own energy advisory committee observes, “[e]xchanges, by virtue of their decades of experience and interaction with market participants, are especially well-positioned to...administer” such limits in a timely manner.

By contrast, it took the CFTC more than 18 years to update the position limit levels for security futures products, which had become out of alignment with comparable limits of equity options. Even the CFTC itself acknowledges this, noting dryly on page 616 of its rule release that “[e]xchange limits may be updated much faster and more frequently than federal limits can be updated.”

Thus, although the CFTC has delivered a much better product here than in the past, there remains a serious disconnect between the effect of position limits and the CFTC’s stated rationale for them. Moreover, it still remains a regulatory regime that arguably could better be administered by the exchanges than by the government.

This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.

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Robert Zwirb is an attorney who has advised market participants on financial regulatory issues. He has served as counsel to a Wall Street law firm, as well as to two former chairs of the Commodity Futures Trading Commission, Wendy Gramm and Sharon Brown-Hruska.