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— Analysis —
While no single culprit has been accused by Capitol Hill detectives yet, a "person of interest" whose reputation they have no qualms besmirching has been named. During scores of congressional hearings in recent weeks, the IntercontinentalExchange, an electronic over-the-counter futures platform based in Atlanta, has been forced to deny accusations leveled by oil market experts and academics who insist that unchecked speculation on the lightly regulated trading operation is the cause of surging oil prices.
Before the recent uproar, the IntercontinentalExchange operated for half a decade with relative invisibility compared with its well-known futures competitors, the New York Mercantile Exchange and the Chicago Mercantile Exchange. How did the seven-year-old operation end up staring into government investigators' desk lamps? ICE, as the IntercontinentalExchange is known, has its roots in the International Petroleum Exchange in London, which became the leading energy futures exchange outside the U.S. It was formed in 1980 to trade the Brent Crude futures contract for a North Sea blend of oil that provides the basis for pricing two-thirds of the world's crude oil trade. The London-based platform operated as a mutual exchange until 2001, when IntercontinentalExchange Inc. acquired it. The IntercontinentalExchange was the vision of CEO Jeffrey Sprecher, who wanted to build a transparent and efficient marketplace for electronic, over-the-counter commodities trading. Sprecher purchased the Continental Power Exchange, or Cpex, in 1997 and then in 2000 persuaded 13 of the top energy players and financial institutions, including Goldman, Sachs & Co., Deutsche Bank AG, Aquila Inc., Morgan Stanley Dean Witter and BP Amoco to join Cpex and form the IntercontinentalExchange. The 13 participants acquired equity interests and committed to provide order flow to the new marketplace. The 2001 acquisition of London's petroleum exchange, now ICE Futures Europe, gave ICE a world-leading contract it needed to take on the venerable Nymex and Chicago Merc and was a major leap toward opening up the energy markets to participants around the world. When it started, ICE relied on old-school open outcry trading, like its competitors. But in 2005, it switched to an all-electronic platform. The move proved a tremendous success for ICE -- and pushed the trading operation toward today's unwanted attention. In February 2006, ICE launched a futures contract for West Texas Intermediate Crude, another global benchmark for oil prices. While Nymex, the primary market of West Texas Intermediate, continued to base WTI trading on open outcry, the electronic platform allowed ICE to initially steal market share. Nymex's subsequent launch of electronic trading, however, has stemmed the loss of WTI market share. Underlining just how inscrutable the exchange is, the Commodity Futures Trading Commission says that ICE's share of WTI trading stands at 30%. The exchange, on the other hand, insists it holds only a 15% share. It's understandable that ICE, under political fire, would try to play down its influence in the marketplace. But its ability to even do so, without CFTC challenging the claim, demonstrates just how little leverage regulators have. ICE has moved into other markets, too. In 2007, ICE acquired the New York Board of Trade -- now ICE Futures U.S. -- and introduced electronic trading to the soft commodity markets, which include coffee, cocoa and sugar. The Nybot had its origins in the New York Cotton Exchange and the Coffee, Sugar and Cocoa Exchange, both of which have been around since the late 1800s. The 120-year-old Winnipeg Commodity Exchange, Canada's only agricultural futures market, now also operates under ICE's wing as ICE Futures Canada. In the first quarter of this year, ICE's futures exchanges achieved record volume of 62.5 million contracts, up 39% from a year earlier. During the quarter, average daily volume exceeded 1 million contracts for the first time. The phenomenal growth of ICE's West Texas Intermediate trading and the uncertainty over its market share have drawn the attention of lawmakers seeking to root out the cause of the oil spikes. The hazy information about OTC trading volumes has prompted critics to label ICE and other platforms "dark markets," susceptible to manipulation by anonymous investors. Lack of data about oil positions on ICE and other over-the-counter trading has prompted lawmakers to introduce roughly a half-dozen bills addressing "speculation" in oil futures. One of the most vocal on Capitol Hill has been Sen. Maria Cantwell, D-Wash. (pictured), chairman of the Commerce Committee's energy subcommittee. Legislation Cantwell has introduced with Sen. Olympia Snow, R-Maine, would give the CFTC more authority to regulate ICE operations for U.S.-delivered energy contracts. Their bill would essentially put ICE trading of West Texas Intermediate under the same CFTC regime as trades on Nymex. Currently, those ICE trades are overseen primarily by London's Financial Services Authority. Despite the presence of ICE Futures's major trading desks in Atlanta and Chicago, CFTC rules allow overseas regulators to take the lead when they provide comparable regulation to the U.S. This exemption to U.S. oversight is referred to derisively by critics as the "London loophole." "It is of critical importance we unmask who is playing in these dark markets," Cantwell says. Indeed, there are distinct differences between the way Nymex and ICE operate. Nymex traders are subject to limits on how many contracts they can hold. ICE Futures Europe does not have such restrictions, prompting some experts to accuse traders of using the London loophole to evade U.S. oversight. Three major legislative initiatives are being considered. One would increase margins for institutional investors and other "speculators" who never take physical delivery of the oil underlying their futures contracts. Another would increase position limits on ICE traders. Finally, energy futures would be disqualified as eligible investments for pension funds. ICE executives argue they are sufficiently regulated by the U.K. and don't need additional oversight. ICE also contends it is a foreign exchange even if its corporate offices are based in Atlanta. So far, the CFTC agrees. ICE chairman Robert Reid came to the U.S. in June in an effort to assure lawmakers during hearings that the exchange does not tolerate excessive speculation, even if it doesn't have strict rules to prevent it. "We know the positions of each of the people trading on our markets, and if they look unusual, then we call them in and ask them questions," Reid told the subcommittee. Nevertheless, facing mounting pressure to step up its oversight, the CFTC has acknowledged the need for better information, and in mid-June Walter Lukken, the agency's acting chairman, announced that the CFTC and the FSA had reached a deal to impose the first trading limits on WTI oil contracts on ICE Futures Europe. Reid insists that institutional investors are playing a relatively little role in the price spikes. Instead, he blames the falling dollar for making U.S. government securities unattractive, leading to a rush into commodities. He told the Senate Commerce Committee in June that since the beginning of 2007, ICE Futures Europe's share of global WTI open interest has declined even as prices rose. "Furthermore," he says, "the total WTI open interest on both the Nymex and ICE contracts has not increased materially over the past year and indeed is significantly lower than its peak levels." Reid also argues that legislative proposals aimed at discouraging institutional investors' participation would reduce liquidity in the markets and would do little to bring down oil prices. Margin levels should be set solely to manage risk the investments pose, he says. "Artificially increasing margin levels on regulated futures markets would drive business either to futures markets in other jurisdictions where there are no such constraints or to off-exchange OTC marketplaces where clearing is not available," he told the Commerce Committee. Reid says margin levels already are 3.5 times higher than at the start of 2007 because of increased volatility in oil markets, with no downward pressure on prices. Consequently, additional margin hikes forced by regulators would not be expected to push prices down either, he says. But critics of ICE say the investment banks that helped found the exchange, particularly Goldman Sachs and Morgan Stanley, have used it to funnel institutional investors into commodities index funds to the detriment of producers who rely on the exchanges to set prices according to supply and demand for the physical product. "These markets do not exist for the purpose of speculation," says Michael Masters, managing member of hedge fund sponsor Masters Capital Management LLC. Because demand from institutional investors has driven the price of commodities beyond their actual demand, Masters says, "many physical commodity market participants are now losing faith in the futures price as a benchmark for their transactions." Masters notes that 10 years ago, physical hedgers -- the farmers and producers looking to lock in prices on their deliveries -- accounted for 79% of the average long positions in commodities futures. The traditional speculators who acted as the necessary counterparties to hedging contracts accounted for 14%, and only 7% were index speculators. Today, however, the numbers have changed: He says index speculators comprise 40% of long open interest; physical hedgers about 34%; and hedging counterparties 26%. Masters dismisses warnings that traders will move to less regulated markets if limits are imposed on institutional investors. "The United States is the largest consumer of energy in the world and the largest producer of food in the world," he points out. "Every U.S.-based physical commodity producer and consumer will favor a futures contract with physical delivery provisions inside the United States." Masters told Congress that some of his fellow investment managers "might be disappointed" in his comments, but he feels he is right to speak out "as a concerned citizen whose professional background has given me insight into a situation that I believe is negatively affecting the U.S. economy." His detractors have pointed out that Masters' portfolio includes the parent companies of major airlines American Airlines, Delta, US Airways and United, all of which have seen their share prices plummet as fuel prices have risen. One of the most outspoken critics of ICE and the CFTC's seeming reluctance to fully oversee its operations in the U.S. is Michael Greenberger, a former CFTC official and now a law professor at University of Maryland School of Law. Greenberger, who worked at the CFTC from 1997 to 1999, was part of the team that drafted a regulatory response to the near collapse of hedge fund Long-Term Capital Management. Greenberger has been pressing Congress to close the "Enron loophole," which was created as part of the Commodity Futures Modernization Act of 2000 and allowed energy commodities trading on deregulated exchanges. The exemption, Greenberger says, led to Enron's subsequent market manipulation and the West Coast electricity crisis and may be permitting unobserved speculation today. He insists a recent attempt to close the loophole, by a provision in the recently enacted Farm Bill, is insufficient because it requires the CFTC to carry out a long hearing process for any contract it believes should be subject to agency oversight. Greenberger agrees that there's not enough data to conclude that institutional investors are to blame for the oil run-up. But he says the CFTC could have obtained that information already if it had the will. "We're not dead certain what is happening, but enough actors believe speculation deserves to be fully investigated," Greenberger says. "Heating oil dealers, airlines, big oil companies and even OPEC will tell you that speculation is rampant in the markets." The Enron loophole has a sordid history: Figuring prominently is former Senate Banking Committee Chairman Phil Gramm, now a senior vice president of investment bank UBS and an economic adviser to Republican presidential candidate John McCain. Democrats blame Gramm for inserting the loophole into the Commodity Futures Modernization Act of 2000 at the behest of Enron Corp., based in Gramm's home state of Texas. His wife Wendy, a former CFTC chairman, sat on Enron's board at the time. Gramm insists he simply duplicated a provision approved months earlier by the House, but McCain's rivals have gleefully jumped on the episode. James Galbraith, a University of Texas economist who is advising Democratic candidate Barack Obama, told the Houston Chronicle that Gramm is "the sorcerer's apprentice of financial instability and disaster." Navigating this debate is Nymex, which also opposes additional margin requirements. But the venerable futures exchange is using worries about oil as an argument to eliminate ICE's competitive advantages. James Newsome, New York Mercantile Exchange Inc. president and CEO, wants ICE contracts to be subject to the same positions limits as those on Nymex. He also criticizes the CFTC's decision to allow non-U.S. exchanges to offer products to U.S. customers pursuant to agency no-action letters. That decision, he says, rather than the Enron loophole allowed ICE to enter the West Texas Intermediate market without full transparency of trading positions. "Complete transparency to the CFTC should be a fundamental requirement for markets that are linked," he says. Newsome rejects the argument that speculators are the underlying cause of climbing oil prices. He says the percentage of open interest on crude oil futures held by nonphysical participants relative to speculators decreased over the past year even as prices were increasing. Numbers showing that institutional investors are dominating the energy swaps markets are probably exaggerated, he says, but the uncertainty over their roles "highlights the need" for better CFTC data on large traders. In the end, both sides in the oil price debate agree on at least one thing: Until policymakers know who is trading and how much, the root cause of the crisis won't be uncovered. Unearthing that piece of information seems a good place to start. |
Lawmakers investigating rocketing oil prices last summer rounded up the usual suspects -- oil company executives. With oil now beyond $140 a barrel, they've widened the pool of suspects. 
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