Political leaders around the world have declared war on speculation. The Obama administration’s Commodity Futures Trading Commission is considering position limits on the trading of energy contracts. UK Prime Minister Gordon Brown and France’s president, Nicolas Sarkozy, urge “improving transparency and supervision of the oil futures markets” to reduce oil price volatility.
Even Pope Benedict has jumped into the fray, calling for global “regulation of the financial sector, so as to safeguard weaker parties and discourage scandalous speculation” in his encyclical “Caritas in Veritate.”
Exchange-traded energy derivatives, including crude oil, refined products, and natural gas, are among the most liquid contracts and offer hedging opportunities extending several years into the future. For example, Nymex crude oil futures contracts extend 8.5 years, and natural gas futures contracts go out 12.5 years. Futures coupled with options contracts provide very useful hedging instruments by serving as substitutes for long-term contracts and vertically integrated corporate structures.
The hedging is done by those with long physical positions, such as crude oil and natural gas producers, and those with short physical positions, such as refined product refiners, marketers, and industrial consumers. It is facilitated by speculators who make the contracts liquid. Hedging is also helped by other financial institutions that tailor exotic derivatives to individual businesses “over the counter.” These financial institutions then hedge their risk exposure using the exchange traded derivatives.
These operations are very complex mathematically and probably beyond the capability of regulators to intervene instantaneously with a positive benefit. Moreover, just the possibility of intervention serves to reduce liquidity and flexibility in developing new contracts. This, in turn, makes hedging substantially more difficult.
Some institutions with physical positions to protect choose not to hedge sufficiently. Instead, they rely on government intervention to relieve them from adverse prices. Typically these are regulated utilities.
The 2000-2001 energy crisis in California is a case in point. The electric utilities could have hedged the volatility of the government-imposed spot electricity market and the cap-and-trade emissions trading scheme using natural gas contracts, but they did not. Instead, the utilities relied on the Federal Energy Regulatory Commission and the South Coast Air Quality Management District to overturn the contracts. This left their nonutility counterparties holding the bag.
The Waxman-Markey cap-and-trade bill recently passed by the House of Representatives has a similar tilt in favor of utilities.
This raises the general question of how likely it is that further government regulation of this practice will protect the poor and weak. Whenever a political allocation of resources is substituted for a market allocation, it favors those with political power. Do the poor and weak have political power? I think not. If they did, they would not be poor and weak.
Finally, it is important to understand that price volatility is a result of changes in demand and supply conditions in the physical market. In the short run, accommodating changes in physical consumption and supply is very costly; hence prices move sharply to achieve equilibrium.
In other words, markets do not create volatility in prices. It is the other way around. Price volatility creates the demand for markets by hedgers.
Government-imposed limitations will not help the markets to function better, and the burden of this failure will fall heavily on the poor and weak.
Jim Johnston ([email protected]) is an economic advisor to The Heartland Institute.
December 18, 1935 – January 21, 2022
