Energy policy and the speculator

THE ENERGY futures market seems arcane, but what goes on there determines the price of gasoline, home heating oil, and ultimately just about anything that requires energy to manufacture. Ironically, the pension funds that are meant to provide a stable future for millions of retirees are creating instability and havoc in that market and, by extension, across the economy.

Congress has the authority to address this problem - and it ought to do so soon.

In futures markets, traders enter contracts to buy and sell specified amounts of certain commodities - such as oil or grain or cattle - for delivery at a specified point in the future. Managers of pensions, endowments, and other investment pools are using these futures markets as substitutes for actual, direct ownership of those commodities. (It's easier to own contracts than to take possession of heads of cattle.) The participation of these investment pools falls under a category commonly called "index speculation" - essentially, the practice of buying up key commodities as specified by broadly accepted market indices.

Portfolio managers who use this strategy aren't looking to buy up undervalued commodities and sell overvalued ones. They participate whether prices are up or down; they maintain positions indefinitely; they buy low and buy high. That may work in stocks over the long term, but commodity futures markets were never intended to be used in this way, and don't work very well when they are.

Futures markets were designed to serve commodity producers and consumers, not index speculators. Unlike traditional traders, index speculators actually drain liquidity from markets. Their positions "crowd out" traditional users of commodities. This results in higher prices and disrupts traditional relationships between physical commodity prices and prices in the futures market, and stability in these relationships is critical to properly functioning markets.

These are highly technical points, but the ramifications are significant. In a submission to Congress, the former head of UBS's commodity division outlined a scenario for a massive failure in the energy futures markets. Such a failure is not farfetched - we already witnessed a similar event in the cotton markets in March.

Worse yet is the trend of all these problems. Index speculator positions total about $260 billion, up from only $13 billion a few years ago. These holdings are only likely to increase over time. Worse for consumers, these interests are heavily concentrated in energy commodities - over 75 percent of the most commonly used benchmark is tied to crude oil, heating oil, gasoline, and natural gas.

Some doubt the impact of speculation. Index speculators are certainly not the only reason that commodity prices have risen - demand growth from developing economies and dollar weakness have been larger factors. But the distorting effects of index speculation are particularly insidious because they undermine confidence in the ability of markets to set a proper price for a commodity. Without confidence that prices are "real," producers won't increase production appropriately, and policymakers can't weigh trade-offs.

Fortunately, there are proven regulatory fixes for this problem.

One is to strengthen rules that limit the participation of speculators. Congress, through its oversight of the Commodity Futures Trading Commission, has the authority to do just that, and must address this critical issue.

"Speculative position limits" have long been used to limit the amount of control any one person or institution could exercise in the market unless they actually produce or consume a given commodity. Unfortunately, too many non-commercial participants were granted exemptions. The restoration of these rules would go a long way toward protecting consumers and markets. Beneficiaries of pensions and endowments would not be unduly burdened by such regulation, since investment alternatives exist.

Investors have long chased performance, driving extreme valuations in technology stocks, real estate, and subprime mortgages. These disruptions have all been created by good intentions, smart people, and sophisticated computer models. This time, we have an opportunity to get in front of the problem. Congress can make the changes necessary to ensure that commodity markets function properly. Without effective legislation in this area, America's long-term energy needs cannot properly be secured.

Jeffrey Korzenik is chief investment officer at Vitale, Caturano & Company in Boston.