London, 27 April 2010

What is the purpose of commodity derivatives? The answer might seem obvious. But responses to the Commodity Futures Trading Commission (CFTC)'s consultation on position limits have revealed fundamental disagreements among leading market users. Every one of the financial participants to have filed a comment has opposed the Commission's proposal for stricter limits, narrower scope for exemptions and tighter positionaggregation.

The Futures Industry Association; the International Swaps and Derivatives Association; and United States Commodity Funds and Deutsche Bank Commodity Services (operators of exchange-traded commodity funds) have all filed responses urging the Commission not to go ahead.

Objections range from legal (the Commission lacks the necessary authority) to practical (the new aggregation system would be administratively tough and expensive to implement). But the core objections are simple. Limits would harm liquidity and diminish opportunities for physical commodity buyers and sellers to hedge and offload price risks; and they would reduce investors' access to instruments with which to diversify their portfolios and hedge against inflation.

Liquid Market Lifeblood

DB Commodity Services is typical when it writes: "A chief objective of the futures market is to provide individuals and companies who maintain price risk in their day-to-day business activities a place to offset those risks via hedging transactions ... A deep and liquid futures market functions as a surrogate buyer or seller until an actual client can be found ... The futures markets exist to allow hedgers to hedge, a function only robust futures markets can accomplish."

"The futures markets also exist to allow speculators a forum to take a view on prices ... [In] the process of speculating (long and short) they create liquidity that allows hedgers to easily hedge and the price of the underlying contract to be properly 'discovered'."

As a consequence, the proposed limits will significantly diminish liquidity, the lifeblood of efficient futures markets. If hedgers lose much of their ability to hedge, the currently transparent price discovery will become opaque as speculators move to over-the-counter (OTC) and overseas markets)" (page 5, DBCS letter to CFTC, April 22).

But some of the customers for whom this liquidity is being provided disagree. There is widespread scepticism about whether they really want this much liquidity.

Too Much of a Good Thing

Every single one of the energy users and distributors that has written to the Commission has urged it to press ahead. Most want the Commission to be tougher and impose limits at lower levels or cap investors' share of the market at a specific percentage.

The Petroleum Marketers Association of America (PMAA) is coordinating the campaign on behalf of retail distributors and sellers of gasoline, heating oil and propane. Dozens of supporting responses have been filed by state-level distributor associations, and individual companies.

For big energy consumers, the Mediterranean Shipping Company (MSC), the Air Transport Association (ATA) and the Industrial Energy Consumers of America (IECA) have all urged the Commission to adopt limits. Each thinks the proposals do not go far enough.

IECA (which represents chemical companies, manufacturers, and steelmakers, among others) is typical when it complains: "Unfortunately, the contract position volumes of the traditional and passive speculators have grown so large relative to the total size of the market and the positions volume of bonafide hedgers that the price discovery of the underlying commodity is threatened" (page 2, IECA letter to the CFTC, April 21).

IECA points out that physical hedgers share of the natural gas market has shrunk from 77 percent in 1998 to just 31% in 2008. "This trend is unsustainable."

Mediterranean Shipping expresses similar doubts: "We accept the benefits of increased liquidity from the noncommercial element of the market and would not suggest their exclusion." But "the volume of physical trade and corresponding hedging activity is not big enough to balance the passive and active positions speculators now hold which cause detachment from the underlying instrument and severe price distortion."

Mediterranean Shipping wants the CFTC to impose limits, but at a lower level than the 98 million barrels of oil indicated at the time the Commission released its proposals in January. IECA is far tougher. It wants passive speculators (commodity index funds) banned altogether.

"It is very important for the CFTC to clearly distinguish the differences between the two types of speculators. There is the traditional speculator that has an important role to play so long as their positions do not become too large. The second type, the passive speculators have no positive role and whose presence decreases liquidity and significantly and negatively impacts price discovery."

Who Are Futures Markets For?

At the root of this dispute is a fierce disagreement about what commodity futures markets are for. Mediterranean Shipping has no doubt. "The oil derivatives markets, as with other commodity markets, were established to help price discovery and allow oil market participants to hedge forward price exposure.

They were not established to allow financial participants to take huge speculative positions and use commodities as another financial investment platform."

IECA expresses the same, restrictive, view. "The futures market is special and unlike any other. It was created to serve the needs of buyers and sellers of consumable commodities and the managing of financial risk associated with these transactions."

Shippers, energy users and retail distributors want the markets to remain small, specialist places where physical producers and consumers retain a privileged role, while speculators even out short-term imbalances by taking dynamic long and short positions.

IECA seems nostalgic for the good old days. "Prior to the year 2000, these markets worked well with prices reflecting the underlying supply versus demand of the physical natural gas market." But since then the volume traded by speculators has increased and "transformed this market from a "commodity" to an "asset" class investment."

No Reason to Exclude Others

In contrast, the financial operators want a much wider definition of the market. United States Commodity Funds points out "Energy prices impact all investors either directly or indirectly and there has been a growing appreciation by investors that it may be appropriate to address the escalation and volatility of energy prices through participant in financial markets."

USCF argues that its products are designed to provide both retail and institutional investors with easy and costeffective access to energy markets. It notes that its flagship U.S. Oil Fund had over 300,000 investors during the course of 2009, while the U.S. Natural Gas Fund had over 400,000.

USCF estimates that between 3 and 4 million "retail" investors hold investments in exchange-traded funds in 2009, based on discussions with other fund managers. USCF believes its funds have democratized markets, allowing the little guy to take or offset price exposure in a manner that was formerly only available to big institutions.

Deutsche Bank also advocates a wider role for derivatives that goes well beyond price discovery and physical hedging. They "allow speculators to express their views on price movements" and via passive index funds "permit investors to hedge against inflation and diversify their investment portfolios."

This is the crunch point. Do commodity derivatives exist solely to permit physical hedging and price discovery, or are they also a financial asset that allows a much broader range of participants (both individuals and institutions) to hedge inflation risks, diversify and take a view on the future?

Should the views and needs of physical hedgers count for more than retail and institutional investors? Does it matter if the financial aspect of price-setting becomes more important than the physical one? Is it even possible? And even if it is, should the CFTC attempt to police the boundary or stand out of the way and allow the market to evolve freely?

Ends --

By John Kemp, Reuters market analyst - for Commodities Now.

The views expressed are his own.