Investors' Growing Appetite for Oil Evades Market Limits
Trading Loophole for Wall Street Speculators Is Driving Up Prices, Critics Say

By David Cho
Washington Post Staff Writer
Friday, June 6, 2008

Hedge funds and big Wall Street banks are taking advantage of loopholes in federal trading limits to buy massive amounts of oil contracts, according to a growing number of lawmakers and prominent investors, who blame the practice for helping to push oil prices to record highs.

The federal agency that oversees oil trading, the Commodity Futures Trading Commission, has exempted these firms from rules that limit speculative buying, a prerogative traditionally reserved for airlines and trucking companies that need to lock in future fuel costs.

The CFTC has also waived regulations over the past decade on U.S. investors who trade commodities on some overseas markets, freeing those investors to accumulate large quantities of the future oil supply by making purchases on lightly regulated foreign exchanges.

Over the past five years, investors have become such a force on commodity markets that their appetite for oil contracts has been equal to China's increase in demand over the same period, said Michael Masters, a hedge fund manager who testified before Congress on the subject last month. The commodity markets, he added, were never intended for such large financial players.

"I've never said that financial speculation is behind all of the recent price increase here, but even if it's some of the reason, it's something society needs to look very hard at," he said.

Commodities have become especially enticing to investors as the credit crisis has roiled other investment opportunities such as stocks and debt-related securities. The recent flood of investment money has transformed the markets for oil, as well as uranium, wheat, cotton and other goods, into a volatile realm that some insiders call the Wild West of Wall Street.

Even as record oil prices translate into staggering increases at the pump, some regulators, including Treasury Secretary Henry M. Paulson Jr., say investors are not to blame. These officials cite supply and demand as a far bigger factor.

Since last year, this was also the position of the CFTC. But agency officials have recently signaled greater concern, saying they want to collect more data to determine whether speculation might be a significant factor. That information can be difficult to obtain because commodity trading often occurs through private, unregulated transactions and on overseas exchanges.

Walter Lukken, the acting chairman of the CFTC, acknowledged in an interview that his agency has had a hard time keeping up with the sector it oversees. Commodity trading has exploded in complexity and popularity, he said, growing six-fold in trading volume since 2000. That was the year a handful of giant energy companies, including Enron, successfully lobbied Congress to ease the regulation of energy markets.

Meanwhile, the CFTC's staffing has dropped to its lowest levels in the agency's 33-year history.

"We could hire an extra 100 people and put them to work tomorrow given the inflow of trading volume," Lukken said. "We are doing the best we can in difficult circumstances. . . . This is something that we are obviously concerned with -- the potential for manipulation."

CFTC officials said in interviews that they planned to re-examine the exemptions granted by agency staff to Wall Street firms. These date to 1991, when complex derivatives used to bet on futures contracts emerged and their significance was little understood. These officials said they would also reconsider the waivers given to overseas trades.

On commodity markets, buyers largely purchase futures contracts, which determine the price goods will fetch on a particular date in the future. Unlike commercial businesses that are trying to lock in prices for coming orders, speculators have little interest in taking actual delivery of oil or other commodities. Instead, these investors trade the contracts like stocks. These investments can be very attractive because there are only light restrictions on whether they can be bought and sold using borrowed money. While risky, this can produce enormous returns.

Some Democratic and Republican lawmakers allege that gaps in oversight are allowing deep-pocketed speculators to manipulate prices.

"Consumers no longer have the confidence that the prices they are paying at the pump are fair or even linked to underlying supply-and-demand forces," said Sen. Maria Cantwell (D-Wash.).

The recent craze in commodity investing is partly due to the emergence of commodity index funds, which act like mutual funds except they hold futures contracts rather than stocks. Such funds have made commodity purchases far easier for a wide range of investors, including hedge funds, investment banks, pension funds and university endowments.

George Soros, one of the nation's leading investors, testified in a Senate hearing this week that index funds were contributing to the rapid rise in commodity prices and were possibly creating a bubble. If it were to burst, sending prices tumbling, the fallout could wreak havoc on banks, retiree funds and colleges across the nation.

"I find commodity index buying eerily reminiscent of a similar craze for portfolio insurance, which led to the stock market crash of 1987," Soros said.

Information on commodity trades can be hard to come by. Some contracts are exchanged privately between two parties who do not have to disclose the transaction. There are also two exchanges that trade oil and other goods in the United States. One, the New York Mercantile Exchange, or Nymex, is closely regulated. The other, Intercontinental Exchange, has set up a market in London, where trading can occur beyond the purview of U.S. regulators.

Nymex is now setting up its own market in Dubai, which the CFTC has given permission to trade oil destined for delivery in the United States. The CFTC has stated that it would not place restrictions on U.S. investors who exchange oil contracts in Dubai but rely on foreign regulators.

Nymex chief executive Jim Newsome said he recognized that Congress's patience with the CFTC was wearing thin. But he warned lawmakers against acting too rashly.

"I think some members of Congress would prefer the CFTC to move more quickly than they have," he said. "But the CFTC are the experts on these markets. And there can be very dangerous unintended consequences when you are dealing with a huge marketplace."

Officials at the Intercontinental Exchange said they worried that some investors would stop doing business with the United States if an "onerous regulatory burden" were placed on domestic markets.

Last week, the CFTC announced a new information-sharing agreement with British regulators who oversee the trading of oil destined for the United States. The agency also took the highly unusual step of revealing an ongoing investigation into possible oil price manipulation.

"I want to make sure these markets are properly regulated and will do everything we can to do that," said Lukken, who faces confirmation hearings in the Senate this week. Several Democrats have warned that they may try to oust him.

Under pressure from voters, lawmakers are pressuring the CFTC to take even more forceful action to regulate the commodity markets.

CFTC Commissioner Bart Chilton acknowledged that the agency should have been quicker to adapt.

"The commission has realized that the ordinary regulatory environment that we've been operating in has transformed dramatically and we need to look at things in an entirely new way," Chilton said. "We haven't been doing all that we needed to do. We've been getting by, and I think it requires more than just getting by."

Michael Greenberger, a professor at the University of Maryland and former CFTC commissioner, said there were loopholes the agency could close without much effort.

"There's smoke here, and the CFTC hasn't wanted to look if there's a fire," he said. "Now they say they want to look, but they need the data. . . . But these are dark markets. They don't even know who's doing the trading."

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