Summary: The CFTC recently proposed limits on the futures and option contracts for energy products, similar to those already existing for some agricultural commodities, to prevent commodity traders from amassing excessive positions that can move the markets.

The Commodity Futures Trading Commission on January 14, 2010, proposed limits on the futures and option contracts for energy products, similar to those already existing for some agricultural commodities, to prevent commodity traders from amassing excessive positions that can move the markets. This has been one of Chairman Gary Gensler's major agenda after some accusations that many speculators, including investment banks and hedge funds, were responsible for driving up gas prices last year through excessive speculation on energy future contracts. These prices rose from $68 a barrel in January 2008 to $147 in July and $33 in December 2008 and $72 in June in 2009.

Some important constituents support the increased regulation, urging Congress to give the CFTC the needed tools to ensure that speculators do not dominate the market. But critics say that there is no empirical evidence that speculators were responsible for the hike in oil prices. The CFTC held a series of hearings in the summer of 2009 with some presenting data that about 75% of trades that ran through thresholds came from hedge funds and money managers.

Central to the CFTC's responsibilities “is our duty to protect the public from undue burdens of excessive speculation that may arise including those from concentration in the market place,” Gensler said. Under an exchange's position accountability rules, once a trader exceeds an accountability level in terms of outstanding contracts held, the exchange has the right to request supporting justification from the trader for the size of its position, and may order a trader to reduce or not increase its positions further. In the twelve months from July 2008 to June 2009, the accountability levels in individual months were exceeded by 69 different traders, Gensler said. “Some actually exceeded on every single trading day of the year.”

The agency is proposing to impose all-months-combined, single-month, and spot-month speculative position limits. The proposal for non-spot-month positions would apply exchange-specific speculative position limits to a set of economically similar contracts that settle in the same manner. Moreover, it would implement and enforce aggregate non-spot month speculative position limits that would apply across registered entities that list substantially similar energy contracts.

The aggregate limits are set by a formula based on open interest. The all-months-combined position limit would be 10% of the first 25,000 of contracts of open interest and 2.5% of open interest beyond 25,000 contracts. The single-month position limit is set at two thirds of the AMC position limit. The spot-month limit in the physical delivery contract is 25% of the estimated deliverable supply. For a small reporting market, the AMC limit would be up to 30% of a contract's total open interest on that exchange. The single-month limit that would apply to a small exchange would be equal to two thirds of that value—or as much as 20%--of the total open interest on that exchange. For new reporting markets, a de minimis AMC limit would be the greater of 5,000 contracts or one percent of all open interest in a referenced energy commodity contract. A trader holding cash-settled contracts would be subject to a spot-month position limit of five times the level fixed for the cash-settled contract's physically-settled counterpart if the trader holds no physically-settled contracts in the spot month.

The proposal also establishes a framework for certain swap dealer risk management exemptions in addition to exempting entities using the futures markets to hedge commercial risks, like an airline purchasing futures contracts to hedge the cost of fuel. Swap dealers establishing positions to offset customer initiated swap positions could qualify for a limited risk management exemption for positions held outside the spot month. The CFTC would cap the exemption at two times an otherwise applicable proposed position limit.

The proposed regulations would cover four referenced energy commodities: Henry Hub natural gas, light sweet crude oil prices, New York Harbor No. 2 heating oil, and New York Harbor gasoline blendstock. And it would cover all CFTC-regulated exchanges—the New York Mercantile Exchange and the IntercontinentalExchange in Atlanta, GA.

The commission estimates that the total number of traders with significant positions that could be affected by the proposed rules would be about 10.

While the vote was four to one in favor of the proposal, three commissioners expressed concern, signaling hard work ahead for Gensler to get the votes needed for a final rule. Among the concerns cited were that the limits could result in less U.S. regulatory oversight. “As we work to increase transparency in these markets, the proposed position limits may undermine our efforts by allowing participants to turn to the less regulated and less transparent over-the-counter markets, which would be detrimental to the markets and to the public,” Commissioner Scott O'Malia said.

The proposal will be out for public comments for 90 days after publication in the Federal Register. The CFTC will hold hearings on limiting contracts in the metals market in March.