Hearings to Curb Energy Speculation by the Likes of Goldman Sachs

Yes!

Spotlight on Goldman as commodities hearings begin
9:06 am ET 07/28/2009 - MarketWatch Databased News
NEW YORK (MarketWatch) -- Goldman Sachs Group Inc., under fire for reaping record trading profits in the teeth of the financial crisis, is now fighting to defend one of its major sources of revenue -- commodities trading -- as regulators consider setting limits on Wall Street speculators.
Goldman and other big investment firms are scheduled to appear at a series of hearings held by the Commodity Futures Trading Commission starting Tuesday, as the Obama administration launches its biggest move yet to clamp down on commodities speculation, which has roiled prices from oil to corn and wheat in recent years.
At issue for the investment bank is a major exemption it enjoys from limits on trading of certain types of agricultural commodities. Such an exemption is usually reserved for traders classified as "hedgers," such as farmers or food producers that depend on stable prices for their businesses.
Goldman opened the door for investment banks to apply for similar status when it won the first exemption 18 years ago to help its big institutional clients in commodity index trading, or investment in a range of commodities by tracking a major index.
The result, according to some members of Congress, has been a surge in all commodities speculation in the last few years, pushing oil prices near $150 a barrel and gold prices over $1,000 an ounce.
Speculators' index trading is "creating price disruptions for producers and consumers," said Sen. Carl Levin, D-Mich., late last month after the release of a 247-page report documenting how index traders have made large purchases on the wheat futures market in Chicago and have pushed up futures prices over the past few years.
It's time for regulators to "change course, rein in commodity index traders, and clamp down on excessive speculation that is disrupting commodity prices," he added.
In addition to taking away the special exemption, the CFTC, the U.S. futures market regulator, is also thinking of adopting position limits on all commodities, not just in agriculture. The move could curb the growth of some major commodities exchange-traded funds.
The commission will hold three hearings, including the one Tuesday. Representatives from Goldman and J.P Morgan Chase Co. , two biggest holders of derivative assets, are scheduled to attend the second hearing on Wednesday.
Goldman argues that any new limits will severely impact liquidity in commodities markets, hurting both large and small investors by reducing their access to these markets. The bank derives almost half of its revenue from trading commodities, currencies and bonds, but it doesn't break out just commodities.
"Attempts to regulate volatility have rarely -- if ever -- succeeded," said Steven Strongin, a Goldman managing director, in testimony delivered last week to a Senate committee regarding Sen. Levin's wheat report. "Yet they often have unintended and significant consequences."
Brad Hintz, analyst at Sanford C. Bernstein & Co., estimated that commodities trading accounts for about 8% to 9% of Goldman's revenue. While the percentage is not as big as fixed-income trading, it's an important sector for Goldman because "there are only a handful of major players."
"It's a powerful, powerful piece of the firm," said Hintz.
The CFTC's rule-making process is still in its early stages, and it's not clear whether the hearings will ultimately lead to the adoption of new rules. Michael Duvally, a spokesman for Goldman Sachs, declined to comment.
Goldman started it 18 years ago
At the crux of the debate are the so-called commodity index investments, the total value of which has been estimated by MarketWatch at about $150 billion. See earlier story on the analysis.
The business started in 1991, when Goldman advised a big pension fund to invest $100 million in commodities by tracking the widely followed GSCI, as the Goldman Sachs Commodity Index has come to be known.
The investment was essentially a bet on the index: If the index rose, Goldman would be required to make payments to the pension fund. In order to protect itself against the risk, Goldman, through its commodities trading arm J. Aron & Co., planned to establish similar buying positions in commodities futures markets.
If commodity prices rose, Goldman's gain in futures markets would offset the payments it had to make to the pension fund.
The so-called swap plan had a major obstacle. Federal rules limit the number of positions a trader can take in some agriculture commodities, such as corn, wheat and soybeans.
While no limits were set in other commodities, the agricultural limits would sabotage the whole swap plan, since index investment covers a range of commodities and a limit in one represents a limit in the whole investment plan.
J. Aron applied for exemption, arguing that the firm should not be treated as a speculator but as a "bona fide hedger" -- a classification usually reserved for farmers, processors, or food producers that enter the futures market to hedge their risks in physical commodities trading.
The CFTC, in a letter to J. Aron dated on Oct. 18, 1991, granted J. Aron the exemption. A copy of the letter was obtained by MarketWatch. See the CFTC letter.
Similar exemptions were granted to other swap dealers, most of them big investment companies.
With the help of swap dealers, more and more institutional investors have diversified their portfolios into commodities to hedge against inflation and a weaker dollar. Their positions have grown so large that legislators and analysts said the trend was pushing commodity prices to levels that couldn't be justified by fundamentals. See earlier story on passive investment.
In a statement released earlier this month, CFTC Chairman Gary Gensler said the agency is considering "applying position limits consistently across all markets and participants, including index traders and managers of exchange-traded funds."
Goldman's Strongin, in testimony before Levin, said passive investment in commodity markets is "a crucial source" of market liquidity, and it was "inappropriately characterized as speculators with no real economic interest in these markets."
Strongin, who had served as a member of the policy committee for the GSCI index, said index investors "rarely invest based on short-term speculative market views," and they "aim to earn a reasonable long-run return."
Setting limits on all commodities?
While the CFTC is considering withdrawing the exemption, it's also considering whether to expand speculation limits to cover all commodity futures, such as oil, metals or natural gas.
Setting limits in all commodities could pose another blow to Goldman, which makes billions of dollars in direct commodities trading.
Goldman's revenues in fixed income, currency and commodities trading stood at $6.80 billion in the quarter ended June, or nearly 50% of the quarter's total revenue.
Setting rules on commodities speculation is "certainly not good news for Goldman," said Jeffery Harte, analyst at Sandler O'Neill. "But the devil is in the details. How are you going to specifically define speculators? We just don't know yet."
The impact of expanding speculative limits to all commodities would put in jeopardy the unlimited access to futures markets that some popular commodity exchange-traded funds now have. The United States Oil Fund and the United States Natural Gas Fund , the two biggest energy ETFs, hold significant positions in energy futures.
Setting position limits on energy futures could also hamper the ability of producers and refiners to hedge their risks. Energy users and retailers sometimes go to a swap dealer to make customized trades, instead of using a standardized futures market. The swap dealer will then go to the futures market to hedge its own risk.
"I will be concerned about artificially limiting the size of positions," said Jeffrey Mayer, chief executive manager of MXenergy, one of the biggest independent retailers of natural gas in the U.S.
"The CFTC should make sure all positions are reported and the categories be broken down more carefully to sort out speculators from commercial hedging interest," he added.
The CFTC had said it will enhance its weekly Commitments of Traders report to separate and categorize swap dealers. The improved COT report also will distinguish professionally managed market positions such as those of hedge funds.