Position Limits On The Way

Jim Brown
 
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For those large traders in crude futures and other commodities the CFTC is about to change the rules. The Dodd-Frank Financial Reform Bill mandates the CFTC to implement a plan to reduce speculation pressures in the market.

The Commodity Futures Trading Commission has a January deadline to impose trading restrictions on commodities including oil, natural gas, silver and gold. The committee is meeting this week to consider those recommendations but they will miss the January deadline to impose the restrictions.

The CFTC Chairman said he will tell Congress that the commission will not be able to meet the deadline. The problem involves the complexity of the futures market. The CFTC has received hundreds of comments from interested parties on the prospective rule change. Commissioners have discussed position limits in no fewer than 75 of the more than 400 meetings with firms including banks, hedge funds and oil companies.

In order to implement new rules the commission must formulate the rule then make an official request for public comments, then consider those comments before the rule can be approved. Currently the agency is exploring a way to phase in the new rules so there will not be a serious hit to the markets if position limits are cut back severely. Commissioners are weighing proposals for splitting positions from spot months and all other months combined. They may move on the spot month limits first since the majority of the volume is in the current month contracts.

The commission is considering position limits based on fixed levels as well as percentages of open interest.

Delta Airlines sent a strong letter to the CFTC demanding that the commission move aggressively to strictly limit position sizes a single firm can hold. Delta lost millions when their fuel hedging program imploded in the 2008 crash. The lost money on the way up because they were not hedged enough and then lost money on the way down then their hedges at a much higher dollar amount declined significantly. If you hedge against oil going higher at $100 and oil goes to $80 instead then odds are good you are going to eat that $20 a barrel.

Morgan Stanley and the Futures Industry Association suggested the CFTC set interim rules because regulators don't have the data they need to institute comprehensive position limits. They believe this will be a learning process for all involved and the data needs to be accurately compiled before unintentionally disrupting the market.

Goldman Sachs, Vitol and Cargill have also met with the CFTC in an effort to help them through the process.

Speculators were blamed by the public, the press and Congress for the spike in crude prices to $147 in 2008. However, for those in the oil community we know that a shortage of light crude was actually the problem. There was plenty of available crude but it was the wrong type. OPEC members fueled the speculation fires because it took the focus off the supply problem. When the high prices triggered the recession, demand plummeted and the supply problem evaporated at least temporarily. Position limits are not going to solve this problem long term.

The CFTC is faced with other problems besides futures contracts. If there is a limit on futures contracts traders can switch to swaps and other derivatives in so called "look alike" contracts. Large banks, hedge funds and oil companies can contract large quantities of oil using various swaps derivatives. These will need to be controlled as well. Otherwise a large hedge fund could buy 10,000 futures contract on the market and then contract with Goldman, Morgan Stanley and others for another 10,000 swaps from each firm. The same fund could also buy futures in overseas markets. It is going to be interesting to see how the CFTC structures the new rules.

There are also entities that are required to hold a large number of contracts. For instance the U.S. Oil Fund (USO) holds very large positions in futures. They do not trade them or speculate in the futures but accumulate contracts as more people invest in the USO. Does this give them an exemption in the rules? If so then hedge funds could simply buy and sell vast quantities of USO stock to accomplish the same goal.

For oil companies hedging their future production there is also a need to move large numbers of contracts. If Chevron, Conoco or Total thought oil had topped at $100 in January they could sell tens of millions of barrels of future production into the futures market with different maturities over the next couple years. This is a valid tactic that is used by many oil companies. If there are position limits will there be enough buyers to allow these hedges?

The CFTC is going to need the wisdom of Solomon and the research capabilities of Google to come up with a rule that works for everyone without breaking the market.

Jim Brown

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