Hearings and Business Meetings

SD-106 02:30 PM

Dr. James Overdahl

Testimony of James A. Overdahl, Chief Economist
U. S. Commodity Futures Trading Commission
Before the Senate Committee on Energy and Natural Resources
September 6, 2005
Mr. Chairman, Senator Bingaman, and Members of the Committee, I appear before you today in
my capacity as Chief Economist of the Commodity Futures Trading Commission, the federal
government regulator of futures and futures options markets in the United States. Energy
contracts falling under the CFTC’s jurisdiction include futures and related contracts on crude oil,
natural gas, heating oil, propane, electricity, and unleaded gasoline. Trading in these contracts
takes place predominately at the New York Mercantile Exchange (NYMEX).
In U.S energy markets, recent experience has shown that even small disruptions in production,
refining capacity, or transportation networks can significantly affect prices in the face of high
demand for energy products. Therefore, given the scale of disruptions caused by Hurricane
Katrina, it is not surprising that current prices for energy products have risen significantly.
Consumers of energy products, who are paying these higher prices, deserve to know that energy
prices are being set fairly in an open and competitive environment.
Futures markets serve energy producers and consumers in two important ways. First, these
markets provide a means for market participants to manage risks arising from their normal dayto-
day commercial activity. This risk-management activity is commonly referred to as
“hedging.” A significant majority of futures positions held over time are established by
commercial users of energy products who hedge their exposure to price risks occurring in the
underlying “cash” energy markets. Second, futures markets are a venue for price discovery. The
prices discovered through the interaction of thousands of traders provide valuable information
even to those who are not direct participants in futures markets. These prices are widely
distributed through newspapers and over the internet and television so that anyone, not just
professional traders, can observe futures market prices and can use these prices as a reliable
benchmark upon which to guide forward-looking decisions. The prices discovered in futures
markets are also used as a benchmark in many types of privately-negotiated, over-the-counter
My purpose here today is to do two things. First, I will briefly describe the methods the CFTC
uses to ensure market integrity. Second, I will address the role played by non-commercial
traders, commonly referred to as “speculators,” in energy markets under the CFTC’s jurisdiction.
Methods used by the CFTC to ensure that energy futures prices are determined in an open
and competitive environment. The CFTC’s mission is to administer the Commodity Exchange
Act (CEA), the statute governing futures trading in the United States. Under the CEA, the CFTC
is the exclusive regulator of futures and futures options markets in the United States. At its core,
the CEA is an anti-manipulation statute, meaning that the CFTC’s primary mission is to detect
and deter market manipulation and other trading abuses. The CFTC relies on a program of
market surveillance to ensure that markets under CFTC jurisdiction are operating in an open and
competitive manner, free of manipulative influences or other sources of price distortions.
The heart of the CFTC’s market surveillance program is its Large Trader Reporting System.
This system captures end-of-day position-level data for market participants meeting certain
criteria. Positions captured in the Large Trader Reporting System make up 70 to 90 percent of
all positions in a particular market. The Large Trader Reporting System is a powerful tool for
detecting the types of concentrated and coordinated positions required by a trader or group of
traders attempting to manipulate the market.
In addition to regular market surveillance, the CFTC conducts an aggressive enforcement
program that prosecutes and punishes those who break the rules. Nearly one-third of the CFTC’s
resources are devoted to its enforcement program. The punishment meted out as the result of
enforcement proceedings deters would-be violators by sending a certain and clear message that
improper conduct will be detected and will not be tolerated.
In addition to the efforts of the CFTC, futures exchanges, such as the NYMEX, also conduct
regular surveillance of their markets under their self-regulatory obligations as defined in the
Commodity Exchange Act. Under the CEA, futures exchanges are guided by a set of eighteen
core principles to ensure that futures trading takes place in an open and competitive environment.
Core principles 3, 4, and 5 speak directly to the duty of futures exchanges to adopt internal rules
and policies and to design futures contracts that reduce the threat of market manipulation and
other sources of price distortions. In addition, Core principle 9 addresses the duty of futures
exchanges to provide a competitive, open, and efficient market for executing futures
transactions. The CFTC oversees compliance with the core principles by conducting periodic
rule enforcement reviews to ensure that the exchanges are enforcing the rules on their books.
Aside from their assigned self-regulatory obligations to the public, futures exchanges also have
private business reasons to make sure that the markets they host operate in an environment free
of manipulation. Even the perception of manipulation is one of the worst fates that can befall a
futures market.
The role of non-commercial traders in energy markets under the CFTC’s jurisdiction.
Data from the CFTC’s Large Trader Reporting System can help answer questions about the role
of non-commercial traders in U.S. energy futures markets. For the unleaded gasoline futures
markets, approximately 80 percent of all open futures positions meet the size threshold for
inclusion in the CFTC’s Large Trader Reporting System. A current snapshot of these reportable
positions shows that non-commercial traders, those who are commonly labeled as speculators
because they do not have an underlying commercial purpose for holding a futures position, hold
about 25 percent of the “long” positions, that is, positions that will appreciate if gasoline futures
prices rise. This current percentage is slightly lower than the average percentage for similar
positions over the past two years. The remainder of open positions, which represent a significant
majority of positions, are held by commercial traders, that is, producers, refiners, and retailers,
who are commonly viewed as hedgers. The CFTC provides on its web site (
www.cftc.gov) a
weekly report, called the Commitments of Traders Report, showing the aggregate positions of
commercial and non-commercial traders based on the CFTC’s Large Trader Reporting System.
The role of non-commercial traders in futures markets has been studied extensively, both by
CFTC economists and others. One can find a long list of academic studies on the role played by
non-commercial traders in affecting a variety of market characteristics across many different
markets. One lesson from these studies is that non-commercial traders are necessary in order for
futures markets to facilitate the needs of hedgers. In order for hedgers to reduce the risk they
face in their day-to-day commercial activities, they need to trade with someone willing to accept
the risk the hedger is trying to shed. Non-commercial traders take on this risk for a price. Noncommercial
traders also add to overall trading volume which contributes to the formation of
liquid and well-functioning markets. Futures exchanges know from experience that the markets
they host cannot exist with hedgers alone. Both hedgers and speculators are necessary for a
futures market to perform its socially beneficial role of transferring risk from those who do not
want it to those who are willing to accept it for a price.
Non-commercial traders are a diverse group with diverse trading objectives. Managed money
traders, including those called hedge funds, fall into the category of non-commercial traders
because they do not have a commercial interest in the product upon which the futures contract is
written. In the futures market for unleaded gasoline, managed money traders represent a sizable
portion of the category of large non-commercial traders captured in the CFTC’s Large Trader
Reporting System. Like other non-commercials, the trading strategies of managed money traders
can vary greatly from one trader to another. On average, managed money traders make up
approximately 75 percent of the non-commercial positions on the “long” side of the market, that
is, the side of the market that would benefit from increases in unleaded gasoline futures prices.
The attached chart provides a snapshot of participation by managed money traders in the October
2005 unleaded gasoline contract traded at the NYMEX. I call your attention to the last three
vertical columns representing the positions of managed money traders in the days immediately
following Hurricane Katrina. As a group, managed money traders reduced their positions, that
is, they were selling, as market prices, represented by the continuous line, were soaring. A
conclusion that can be drawn from this chart is that managed money traders, and speculators in
general, do not have perfect foresight.
Managed money traders also represent a significant share of traders speculating on prices across
related markets. A common trading strategy is to simultaneously establish offsetting positions
between crude oil and the products that are refined from crude oil, that is, gasoline and heating
oil. This trading strategy is referred to by traders as the “crack spread.” In the past week, prices
for refined products have moved much higher, on a percentage basis, than prices for crude oil. A
conclusion that can be drawn from the behavior of the crack spread is that the increase in
gasoline prices following Hurricane Katrina are being driven primarily by disruptions to the
refining process, and not as much from increases in the level of crude oil prices.
As I mentioned earlier, an important benefit to society provided by futures markets is price
discovery. Looking at NYMEX futures prices for wholesale unleaded gasoline over the next
year, one can see that the market expects prices in the future to fall back to levels close to where
they were before Hurricane Katrina. Overall however, the futures market reflects expectations
that gasoline prices a year from now will be significantly higher than prices a year ago. Of
course, such expectations depend on many variables, including how quickly refinery facilities
and transportation networks return to normal operations. I look forward to your questions.