IntercontinentalExchange Inc. (ICE) and CME Group Inc. (CME) have seen severe declines this week after new proposals for energy regulation were released. The restrictions are aimed at reducing volatility in energy prices which threaten to choke off economic growth in the global economy. Statements from the US commodities futures regulator (the CFTC) as well as from UK Prime Minister Gordon Brown call for limits to the positions speculative traders are allowed to take.
The argument made by the regulatory bodies is that energy speculators are helping to push the price of oil to unnaturally high levels. Many institutional traders with no natural exposure to oil prices have bought futures contracts representing significant holdings in oil and other commodities largely as a hedge against inflation. So in order to curb the recent rise in energy prices, regulators are seeking to place position size limits for non industrial traders. It is expected that reducing the level of exposure each trading entity can take will actually decrease the volatility in the markets and lead to lower prices for consumers and businesses that actually need to purchase oil or petroleum products.
According to Senator Byron Dorgan (a democrat from North Dakota), the measure is a good first step to curb “oil speculators looking for a quick buck at the expense of American consumers.” Ironically, this view of markets and economics flies in the face of conventional wisdom and could actually harm oil and other commodity market liquidity and increase the amount of volatility in these important exchanges.
Traditionally, free markets provide a mechanism for finding the true economic value of whatever asset is being traded. A large number of buyers and sellers makes for the most efficient price levels because the multitude of differing opinions and motivations will likely mirror the true level of supply and demand. When supply and demand meet at a particular price, all known economic variables are typically factored into the price of this particular commodity.
When prices on financial exchanges differ from the production or consumption economic dynamics, there is nearly always an arbitrage opportunity which will eventually drive prices back to equilibrium. For instance, if oil futures prices are unnaturally high, it is very easy for a drilling company to sell significant quantities of oil futures contracts at a high price and then deliver the oil (which was produced at a much lower cost) against these contracts. If prices were unnaturally low, a similar opportunity would exist for traders on the consumption side to buy future oil needs at a steeply discounted price. The ability to hedge and speculate over time will drive prices to their natural equilibrium which is dictated by supply and demand forces and not by regulation.
However, when regulators step in and attempt to influence the price of particular commodities, the law of unintended consequences will usually overshadow any positive outcome. Reducing the number of participants will almost certainly increase the price volatility which actually hurts consumers. With uncertainty surrounding oil prices, businesses will be less likely to make long-term plans for production or consumption – especially if they are prevented from hedging their exposure.
It should be noted that hedgers and speculators must co-exist in a market place in order for each participant to be successful. Speculation involves taking on risk with the expectation of a return in the future. On the other hand, hedging involves laying OFF risk and usually giving up some expected return in exchange for the business stability. If speculators are not allowed to take the other side of the trade so that hedgers can lay off exposure, the market will cease to function or will function with limited effectiveness. So while the regulators intent is likely to protect consumers from fluctuating prices, the action proposed will likely have a much different effect in the long run.
It is certainly true that oil prices have been more volatile in the last two years than nearly any other historical period. But the volatility is likely more a function of our uncertain economy rather than speculators pushing the price in one direction or the other. Mid year 2008, prices were at record highs as investors feared “peak oil” where the availability of world oil supplies were in question. However, the decreasing demand for energy as a result of the global recession caused oil prices to quickly drop. Arguably these prices were unnaturally low because they reflected the fear of a complete economic melt down.
As we work our way out of the fearful period, oil prices are rising but likely reflect a more accurate balance between the “peak oil” long-term supply issues and the weak economy short(er)-term demand issues. It is reasonable to see large fluctuations in prices given the true fundamental uncertainty in the market.
As regulations appear to be on the horizon, IntercontinentalExchange has been particularly hard hit because of its exposure to energy trading. However, the selling looks to be a bit overdone as ICE has many other products which bring in revenue and while energy trading may be muted, there will certainly still be a market for the futures and OTC contracts handled by ICE. The low price likely represents a buying opportunity and the ZachStocks Growth Model may soon add to its position in order to take advantage of the low price.
FD: Author has a long position in the ZachStocks Growth Model
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