When Olav Refvik wanted to boost the price of heating oil to make a lucrative energy deal even more lucrative, the Morgan Stanley trader locked up several storage tanks the bank owned near New York Harbor to squeeze supply. Far from being illegal, the maneuver -- which earned him millions and the moniker "King of New York Harbor" -- is business as usual in the "regulated" commodities market.
The rough-and-tumble Chicago-based commodities market is an unusual beast on Wall Street, where practices that would be frowned upon at the flashier New York stock exchange, are considered quite acceptable.
While less glamorous than its East Coast cousin, the commodities markets are critical to most Americans. That's because its traders are integral in establishing the price we pay for oil at the pump each day. When Morgan Stanley, Citigroup and Royal Dutch Shell squirreled away 80 million barrels of crude oil -- nearly enough to supply the entire world for a day -- in supertankers off the Gulf of Mexico last January, they too profited as the price at the pump rose.
But now, as a comprehensive climate bill wends its way through the House of Representatives, some of these aggressive commodities practices have come under scrutiny. New legislation proposed by Rep. Waxman (D-Calif.) and Rep. Markey (D-Mass.) would create a system of carbon allowance permits that the government would sell to companies that want to circumvent new emissions requirements. These permits would end up spurring as much as $2 trillion in new carbon-based "derivatives." In this case, these new derivatives, so-called because they derive their value from something else, would be traded on the commodities markets, and without proper regulation, critics worry their prices could be manipulated much in the way that traders influence the price of oil.
With the combination of the upcoming climate bill that that could create a major new commodity derivatives market, in addition to a new focus from the Obama administration on derivatives, experts are hoping that regulation will be strengthened. Experts and legislators say these two forces have created a perfect storm, and that the opportunity is ripe to take a broader look at the overall commodities market rather than be limited to reforming only derivatives.
President Obama last week called for the overhaul Wall Street, and as part of his proposal, he zeroed in on regulating over-the-counter (OTC) derivatives, or those instruments that are bought and sold via verbal contracts. Because they are not traded on an exchange, OTC derivatives leave no paper trail and lack transparency. At this time, it seems probable that the pollution derivatives would be traded over the counter.
"On the road to reform we shouldn't be leaving any loopholes," Warren Gunnels, a senior policy advisor to Sen. Bernie Sanders (I-Vt.), told the Huffington Post. "It's important that we not just look at OTC derivatives, but also see how this whole commodities market can be more transparent."
Sanders is one of a five legislators who has proposed legislation in recent weeks that would change the freewheeling Chicago market by strengthening regulations and, in some cases, bolstering the oversight powers of the Commodities Futures Trading Commission (CFTC). Sanders is hoping to compel the CFTC to invoke its emergency powers to stop traders from participating in excessive oil speculation.
Other legislation related to reforming the commodities markets includes an amendment in the climate bill sponsored by Rep. Bart Stupak (D-Mich.) to close several commodity market loopholes; a proposal by Sen. Tom Harkin (D-Iowa) to put all commodities trades on transparent exchanges, and a bill by Rep. Collin Peters (D-Minn.) that originally called for expansive changes for commodities but that was substantially weakened after going through committee.
One of the most pressing issues addressed by much of this new legislation is the role of large bank holding companies like Goldman Sachs and Morgan Stanley. The firms earn billions of dollars in revenue by buying and selling commodities that they trade for proprietary accounts. At the same time, they own thousands of miles of oil and gas pipelines and vast warehouses, and use this infrastructure to gather non-public information to help them develop strategies to maximize profits. While they are not supposed to use this inside information to manipulate prices, they often do, say the experts.
"There is much in the energy market that would be considered insider trading on Wall Street, but is completely acceptable in the commodities market," said Tyson Slocum, the director of the energy program at Public Citizen. Goldman Sachs, Slocum says, should be considered "an energy company" and has been increasingly buying up pipeline and storage facilities. "Then say they are only using the acquisitions to hedge positions on their infrastructure. What they are really doing is getting an insider peek into information that gives them a significant edge," Slocum said.
When asked to comment on how they use this proprietary information, Goldman Sachs declined to comment and Morgan Stanley didn't return calls.
Central to the practices in Chicago is that the CFTC has historically been a weak regulator. Congress stripped the CFTC of much of its power in the 1990s and 2000 as a result of lobbying from Enron and a sympathetic administration. Its powers have yet to be reinstated, which means there is little in the way of limits on how many commodity contracts traders can buy and sell, and there are only minimal capital requirements.
This means that, much like with the housing bust, banks can borrow continuously to fund their speculation without having to hold much capital, or so-called 'skin in the game.' The same is true with hedge funds, which do not have to register with the CFTC. This is worrisome, according to the experts, because if the big traders over-leverage themselves as a result of the lax capital requirements, they will be unable to pay out their contracts should the value of commodities suddenly drop. That could lead to a market collapse much like the one that has taken place with real estate.
Another issue is the electronic trading platforms. While many commodity derivatives are traded over the counter, with no oversight, commodities of all kinds are also traded on two other types of platforms: There is the traditional NYMEX, which is the most heavily regulated of the commodities markets and operates like the stock exchange, and another, only lightly regulated electronic market, the most popular of which is IntercontinentalExchange, or ICE.
London-based ICE, which counts among its founding members Goldman Sachs, BP and Shell, was under no regulatory oversight until last year, when the Republican-led CFTC entered into a voluntary agreement. Under the terms, ICE was to send the agency data on its trades, and the CFTC also gained the right to regulate individual commodity contracts if it could prove it could be related to anti-competitive behavior.
The agreement with ICE hasn't had much of an effect, however. That's because ICE's computer software isn't compatible with the CFTC's system, and what data the regulator can read is often "months old and useless," said Slocum, citing conversations with frustrated CFTC enforcement officials.
A CFTC spokesman told the Huffington Post that it receives data daily from ICE and that they are able to glean useful information from the reports. The spokesman, David Gary, added that the agency had asked the Obama administration for technological upgrades to its computer systems as part of a proposal for additional funding.
"The ability of federal regulators to investigate market manipulation allegations even on the lightly-regulated exchanges like NYMEX is difficult," Slocum testified earlier this year at a hearing of the House Committee on Agriculture. He cited a case in which the Department of Justice took four years to investigate allegations of a single day's worth of price fixing. "If it takes the DOJ four years to investigate a single day's worth of market manipulation, clearly energy traders intent on price-gouging the public don't have much to fear," Slocum said.
While numbers are hard to come by, Morgan Stanley said in its November 2008 SEC filing, that it held $18.7 billion in commodity futures, options and swaps. In its annual report, the company said that commodity revenues had jumped 62 percent. The bank also reported to the SEC that it had committed $452 million solely to lease petroleum storage facilities in 2009.
As for Goldman, 17 percent of if its $22 billion in revenue in 2008 came from fixed income, currency and commodities, which includes all of its energy trading business. Meanwhile, Citigroup's trading division, Phibro, reported the total value of its commodity derivatives increased to $214.5 billion in 2008, a 384 percent increase from 2004. Bank of America held $58.6 billion in these derivatives as of September 2008.
Overall, energy experts said they would be watching to see how the legislation proceeds. "In my opinion, we haven't served the problem of excessive speculation, and whether these reforms will at that is questionable," said Mark Cooper, the research director of the Consumer Federation of America. "We would like to see all of the loopholes closed since it really is the ordinary American consumer who is paying the price in the form of higher prices."
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