The US Commodity Futures Trading Commission (CFTC) has made another proposal regarding the speculative position limits on commodity derivatives which have energy firms on edge. The earlier proposal of the CFTC was rejected by the federal courts in September 2012.
Why CFTC is pushing position limits
According to the Wall Street Transparency and Accountability Act of 2010 (Dodd-Frank), CFTC must amend the position limits for commodity markets in order to conform with the law. The Dodd-Frank Act had amended position limits on certain assets in 2010 but had exempted 28 core physical commodity futures, swaps and options.
The CFTC proposes that the speculative position limits should be established for the exempt derivatives in order to control the volatility in prices of essential commodities (such as fuel and food grains). The purpose of position limits is to “guard against concentration and manipulation, without unduly restricting the liquidity provided by speculators to our derivatives markets,” says David Sheradon in his comment to the CFTC.
“A 2011 Better Markets study shows that 70 percent of the Chicago Board of Trade’s wheat contracts from 2006 to 2010 were controlled by financial speculators, not by traders or processors of wheat. Commodity index fund speculators, with the long-term investment horizons of their pension fund and endowment investors, bet on prices to increase and induced extreme price volatility as they bought and sold contracts according to the fund formula,” analyzes Steve Suppan of the Institute of Agricultural and Trade Policy.
What will be the Impact?
The proposed rule of the CFTC would impose both spot-month and non-spot month position limits across 19 agricultural contracts, four energy contracts and five metal contracts. “Spot month position limits will generally be set at 25% of estimated deliverable supply, while non-spot position limits will be set using a formula based on open interest – 10% of the first 25,000 contracts of open interest and 2.5% of any remaining open interest,” reports Alexander Osipovich.
Furthermore, cash-settled contracts will be subject to higher limits than the physically deliverable contracts. The spot-month position limit on cash-settled contracts would be five times higher than the normal limit but “but a trader in the spot month may not net across physical-delivery and cash-settled contracts,” says the CFTC.
Market participants feel that this would dampen the liquidity of the market, making it difficult for energy firms to hedge effectively. Additionally, the conditional spot-month limit exemption is a major issue in the natural gas market. The rule will favor one of the two natural gas standard contracts of Henry Hub (which is physically deliverable) and Ice’s natural gas (which is cash-settled).
Energy firms to bear the brunt of new regulation
The hedge exemptions available currently to energy companies have also been amended. The Dodd-Frank Act requires these companies to abide by new restrictions in order to be able to override the exemptions. These restrictions include unfilled anticipated requirements for resale by a utility, royalties, and service contracts. Energy firms feel that these are overly restrictive and make it difficult for the companies to hedge their bona fide risk effectively.
A second major setback for energy firms is the trade option would also count towards position limits under the new regulation. This provision would ensure compliance on part of market participants and make it difficult for them to dodge the directives of CFTC.
Analysts believe that if these rules are approved and implemented in the second round, large speculators would be essentially eliminated and funds would no longer have this lucrative trade as an option to park their funds. Energy market participants fear that the regulation would make it difficult for oil and gas exploration companies to hedge their risk, discouraging activity in this area.