1. Market Speculation and Energy Prices: A Congressional Perspective Presentation to UH-GEMI Energy Trading Conference January 25, 2007 Dan M. Berkovitz Counsel Permanent Subcommittee on Investigations United States Senate (Senator Carl Levin)

2. 2 Outline of Presentation I. What is the Senate Permanent Subcommittee on Investigations? II. PSI Report (2006) on Speculation and Energy Prices III. Prospects for Legislation Affecting Energy Trading

3. 3 Senator Harry Truman’s investigation during WWII of war profiteering led to the creation in 1948 of the Senate Permanent Subcommittee on Investigations (PSI).

4. 4 PSI Energy Price Investigations In the mid-1970s, PSI jurisdiction expanded to include energy supplies and prices under chairmanship of Senator “Scoop” Jackson. –Investigated national security implications of Arab oil embargo –Investigated structure of the oil industry and role of oil majors in pricing Recent investigations under Chairman and Ranking Minority Member Carl Levin: –Gasoline price report and hearings (2002). –Report on oil prices and regulation of energy markets (2003). --Report on the role of speculation in rising energy prices (2006).

5. 5 2006 Report: Findings on Speculation 1.There has been a large increase in the amount of financial speculation in energy markets. 2.This increase in speculation contributed to increased prices. 3.This increase in speculation shifted traditional price-inventory relationships. 4.Electronic markets involve the trading of standardized, cleared contracts that are functionally equivalent to futures and perform a price discovery function. 5.The disparity in regulation of various energy markets (Designated Contract Markets vs. Exempt Commercial Markets) impedes market oversight and the ability to prevent price manipulation.

6. 6 What is Speculation? A speculator “does not produce or use the commodity, but risks his or her own capital trading futures in that commodity in hopes of making a profit on prices changes.” --CFTC. Potential benefits of speculation: –Increases liquidity. –Commercial entities are able to transfer risk of price changes. –Finances storage. Potential disadvantages: –Excessive speculation can cause prices to deviate from the fundamentals of supply and demand. –Increased volatility increases costs of hedging and makes it more difficult for commercial participants to determine when to hedge.

7. 7 CFTC Has Mission to Prevent Excessive Speculation Section 4a(a) of the Commodity Exchange Act directs the CFTC to establish limits on speculation: “Excessive speculation in any commodity under contracts of sale of such commodity for future delivery made on or subject to the rules of contract markets or derivatives transaction execution facilities causing sudden or unreasonable fluctuations or unwarranted changes in the price of such commodity, is an undue and unnecessary burden on interstate commerce in such commodity. For the purpose of diminishing, eliminating, or preventing such burden, the Commission shall, from time to time, after due notice and opportunity for hearing, by rule, regulation, or order, proclaim and fix such limits on the amounts of trading which may be done or positions which may be held by any person....” CFTC imposes speculative limits on energy futures just prior to contract expiry to ensure orderly trading near expiry.

8. 8 Speculative Limits for Energy Contracts Market Net All Months Combined Net Single Month (Other Than Spot) Spot Month Crude OilNone 3,000 for last 3 days Reformulated Unleaded Gasoline None 250 for last 3 days RBOB Unleaded Gasoline None 1,000 for last 3 days Natural Gas, Henry Hub None 1,000 for last 3 days Natural Gas, Basis Swaps None 500-2,500, depending on contract No. 2 Heating OilNone 1,000 for last 3 days ElectricityNone 500-3,000, depending on contract

9. 9 Increase in Speculation Commodity Indexes –Goldman Sachs estimates that approx. $110 billion now invested in GSCI and other indexes, up from $70 billion in 2005 and $15 billion in 2003. –Index investments are generally long investments. –Marketed as portfolio diversification. –Pension funds, large institutions, and hedge funds are major investors. Hedge Funds –In 2006, NY Times reported an estimate of at least 450 hedge funds with $60 billion in assets focused in energy and environment; including 200 devoted exclusively to energy. –News reports of energy hedge fund collapses in 2006 indicate some funds use highly speculative strategies. –Absence of reporting requirements makes increased hedge fund investment difficult to quantify.

10. 10 Increase in Energy Trading: Increase in Open Interest in Futures Contracts

11. 11 Increase in Non-Commercial Trading in Natural Gas Futures

12. 12 Increase in Non-Commercial Trading in Crude Oil Futures

13. 13 Increase in Crude Oil Prices

14. 14 Crude Oil Prices Hit Record Highs Despite High Inventories

15. 15 Speculation: A Contributor to High Oil Prices “With the demand from the investment community, oil prices have moved up sooner than they would have otherwise.” –Former Federal Reserve Chairman Alan Greenspan (2006) “Senator, the facts are—and I’ve said this publicly for a long time—the oil prices have been moving steadily up for the last two years. And I think I have been very clear in saying that I don’t think that the fundamentals of supply and demand—at least as we have traditionally looked at it, have supported the price structure that’s there.” --Lee Raymond, Chairman and CEO, ExxonMobil (2005). “There has been no shortage and inventories of crude oil and products continue to rise. The increase in price has not been driven by supply and demand.” --Lord Browne, Chief Executive of BP (2006). “In summary, increased purchases of long-dated crude lift the forward price curve. The rise in prices is reflected back to contracts maturing in a few months.... [T]he impact of increasing stocks has been overwhelmed by the strong demand for forward crude, which has added as much as $24 per barrel to prices.” --Philip Verleger, Petroleum Economist

16. 16 Speculation Shifted the Relationship Between Crude Prices and Inventory

17. 17 Speculation Helped Elevate Crude Oil Forward Curves For years 1999-2002, the dates reflect the forward curve as of December 1. For other years, the dates reflect the forward curve as of Dec. 2, 2003; Dec 6, 2005, and April 1, 2006.

18. 18 Speculation Helped Elevate Natural Gas Forward Curves

19. 19 Increase in Speculation on ICE (Intercontinental Exchange) Source: ICE, Form 10-K (2006).

20. 20 Disparity in Regulation Between NYMEX and ICE

21. 21 PSI Report Recommendations Require Large Trader Reports for futures “look-alike” trades (e.g., ICE Henry Hub natural gas swaps) on electronic exchanges. Require Large-Trader Reports for U.S. energy commodities traded from a domestic terminal on a foreign board of trade (e.g., WTI on ICE Futures). CFTC should issue regulations to increase dissemination of daily trading from the ICE electronic exchange. –CEA §2(h)(4)(D) requires CFTC to issue regulations to provide for public dissemination of trading data (e.g., volume, open interest, price data) for electronic trading facilities that perform a price discovery function in the cash market for the commodity. Close “Enron loophole”.

22. 22 Subsequent Relevant Developments CFTC-FSA agreement to share data. –The agreement is vague as to the extent of sharing of real-time trading data. CFTC modification of COT reports. –COT reports provide key information about speculative investments in commodity futures but have not kept pace with market changes. –New COT report provides Increased detail on nature of non-commercial hedging. –Changes apply only to COT reports for agricultural commodities.

23. 23 Senate Legislation S. 2642 (109 th Congress) (Sens. Feinstein, Snowe, Levin, Cantwell): –Would require Large Trader Reports for futures-like trades on electronic markets –Would require Large Trader Reports for trading within the U.S. of U.S. energy commodities on foreign exchanges Anticipate re-introduction of the same or similar bill.

24. 24 Support for S. 2642 Agricultural Retailers Association (ARA) Air Transport Association (ATA) of America American Public Gas Association (APGA) American Public Power Association Consumer Federation of America Consumers Union Industrial Energy Consumers of America National Association of Wheat Growers National Barley Growers Association New England Fuel Institute (NEFI) Pacific Northwest Oil Heat Council Petroleum Marketers Association of America (PMAA) Petroleum Transportation and Storage Association 30 State Petroleum Marketing Associations

25. 25 House Legislation Previous Congress: House-passed CEA reauthorization bill contained an amendment sponsored by Rep. Graves –Requires CFTC to review “significant and highly unusual” price changes in natural gas futures contracts to determine whether manipulation has occurred. –Enhanced recordkeeping and reporting for all natural gas positions. Current Congress: H.R. 594 (Rep. Stupak + 18 cosponsors) –Eliminates “Enron loophole.” –Recordkeeping and reporting for large trades in all electronic and OTC energy markets that perform a price discovery function.

26. 26 References PSI Report on Speculation http://hsgac.senate.gov/index.cfm?Fu seaction=Subcommittees.Home&Sub committeeID=11&Initials=PSI http://hsgac.senate.gov/index.cfm?Fu seaction=Subcommittees.Home&Sub committeeID=11&Initials=PSI (scroll down the page) Data sources: NYMEX, CFTC, ICE, EIA. dan_berkovitz@hsgac.senate.gov