Excessive Speculation and Commodity Markets

1. Excessive Speculation and Commodity Markets Separating Myths from Realities Gene Guilford, President of the Independent Connecticut Petroleum Association in Presentation to the House Democratic Caucus. May 16, 2012

2. 2002 - ENRON • In 2000, one of Enron’s subsidiaries did something that was both stupid and criminal: it created an artificial energy crisis in California. Increasing demand through phony power-plant shutdowns and rolling blackouts, Enron drove up the price of electricity and its own profits. But this also focused the attention of journalists and federal investigators on the parent company, whose stock prices had never been higher. • In 2001, the Enron scandal came to light, resulting in massive stockholder defections. In December of that year, the company declared bankruptcy, its formerly golden stock now worthless. Because of its silent complicity in the Enron scandal, the Arthur Andersen company was also forced to close its doors. • In the end, 90,000 people lost their jobs; Enron employees, who had been encouraged to invest their retirement plans in company stock, lost $2 billion into the bargain. Stockholders lost another $70 billion in the Enron scandal, and the state of California sued for $6 billion in energy losses. • Why did this happen? Federal regulators that had been blinded by the 2000 Commodity Futures Modernization Act and some complicit regulators at the CFTC who did not want to see what was going on in the OTC markets. Gene Guilford - House Democratic Caucus - May 16, 2012

3. 2004 – Congress Requested A GAO Study of Commodity Markets and Existing Federal Authorities • We worked with Congressman Larson and others as the Energy commodity markets appeared to become more volatile in the previous four years, combined with price changes that tended to not reflect supply and demand, and south a GAO review of existing federal legal and regulatory authorities; • The 2007 GAO report back to Congress, GAO found that growth in several key areas, including the number of noncommercial participants in the futures markets (including hedge funds), the volume of energy futures contracts traded, and the volume of energy derivatives traded outside of traditional futures exchanges – as contributing factors in energy commodity price movements; • While the exempt commercial and OTC markets are subject to the Commodity Exchange Act’s [CEA’s] anti-manipulation and anti-fraud provisions and CFTC enforcement of those provisions, some market observers question whether CFTC needs broader authority to oversee these markets. CFTC is currently examining the effects of trading in the regulated and exempt energy markets on price discovery and the scope of its authority over these markets—an issue that will warrant further examination as part of the CFTC reauthorization process. Moreover, because of changes and innovations in the market, the methods used to categorize these data can distort the information reported to the public, which may not be completely accurate or relevant. • The CFTC was largely blinded to being able to see what was occurring in the energy commodity markets, especially within the Over-The-Counter and electronic trading and off-exchange trading. • GAO Recommended that Congress should consider further exploring the scope of the agency’s authority over energy derivatives trading, in particular for trading in exempt commercial markets. In addition, GAO recommends that CFTC improve the usefulness of the information provided to the public, better document its monitoring activities, and develop more outcome-oriented performance measures for its enforcement program. Nothing happened. Gene Guilford - House Democratic Caucus - May 16, 2012

4. 2006 – Amaranth LLC • Amaranth Advisors LLC went bankrupt in Oct. 2006. By mid 2007 the Committee of Homeland Security and Government Affairs released a document containing a detailed investigation of the Amaranth scandal entitled “Excessive Speculation in the Natural Gas Markets.” Amaranth, hedge fund, was launched in 2000 as a multi-strategy hedge fund, but had by 2005-2006 generated over 80% of their profits from energy trading. • Amaranth became a high profile entity employing leverage to push prices of a high profile strategic commodity like natural gas higher. This put Amaranth at odds with the 2 % inflation “kool-aide” illusion that the Fed and U.S. regulators were [and still are] trying to falsely sell the American people. In 2008, Ludwig Chincarini CFA, Ph.D, penned a paper chronicling Amaranth’s collapse titled, Lessons from the Collapse of Amaranth Advisors L.L.C. [and found at http://pages.pomona.edu/~lbc04747/pubs/pub9.pdf] The report gave details regarding Amaranth’s management style and risk management practices as well as chronologically detailing the last days of the hedge fund. • As Amaranth began accumulating positions at the NYMEX that the exchange considered excessive, the hedge fund switched its trading to the Intercontinental Exchange [ICE], which was unregulated and beyond the view of domestic market oversight. • The $4 billion collapse of this hedge fund, and its use of excessive leverage to drive natural gas prices higher with its financial positions, illustrates how one financial market player’s actions drive up the cost of energy to consumers and did so largely outside of the view of market regulators. Gene Guilford - House Democratic Caucus - May 16, 2012

5. 2006 - BP Propane Market Manipulation • In 2006 BP’s propane division paid $303 million to settle civil charges that it cornered the propane market eight years ago and inflated heating and cooking costs for about 7 million mostly rural American households • By the end of February 2004, BP controlled almost 90 percent of all the propane delivered on a pipeline that stretches from Mont Belvieu, Texas, to consumers as far away as New York, Pennsylvania and Illinois, investigators said. From the beginning of the month to Feb. 27, the cost of the liquid that is stripped from natural gas skyrocketed by more than 40 percent to about 90 cents per gallon — “a price that would not otherwise have been reached under the normal pressures of supply and demand,” investigators said. • Robert G. Hansen, the associate dean at Dartmouth’s Tuck School of Business, said it appears that “a corporate management failure occurred at BP” and that, with energy markets facing such a high level of scrutiny from the public, “management has to have the utmost control of their trading groups.” • BP traders bragged that if their scheme worked they would “be able to control the market at will.” • The role of rampart speculation in the oil market was noted in 2006 by the U.S. Senate Permanent Subcommittee on Investigations in the report "The Role of Market Speculation in Rising Oil and Gas Prices: A Need to Put the Cop Back on the Block." At that time the report stated: "Several analysts have estimated that speculative purchases of oil futures have added as much as $20-$25 per barrel to the current price of crude oil, thereby pushing up the price of oil from $50 to approximately $70." That report called for ending the Enron Loophole at that time but nothing was done. • BP had traditionally performed most of its trades in the UK markets and was only caught through its US activities. Gene Guilford - House Democratic Caucus - May 16, 2012

6. The New Money Machine • Banks used new academic research to pitch commodities as a safe way to diversify. In one 2004 presentation, Heather Shemilt, then a managing director and now a partner at Goldman, called the strategy “the portfolio enhancer.” That same year two professors, Gary B. Gorton of the Wharton School and K. Geert Rouwen-horst of Yale University, published a paper, funded in part by American International Group Inc., which argued that an investment in a broad commodity index would have brought about the same return as stocks from 1959 to 2004, and would often rise when stocks fall. • Under the crystal chandeliers of San Francisco’s Palace Hotel in June 2005, Rouwenhorst presented his findings to more than 100 investment pros; Shemilt also appeared, alongside managers from Barclays and AIG. After the talk, many in the audience had the same question: How do I do this? • Barclays, Goldman, AIG, and other firms had developed ways to help them do it -- several types of investments based on futures contracts, which had been used for almost 150 years to arrange the price and delivery of a given commodity at a specified place and date. These products remained the province of wealthy investors. In 2004, however, Deutsche Bank’s Rich devised a commodity ETF that opened the door to retail investors when it launched two years later. • The Commodity Index Fund is born. Today these funds plow in excess of $400 billion into commodity markets, distorting their values and providing phantom price signals by people who do not deliver or buy anything – only bet on the paper. • A common myth concerning index funds is that they “provide liquidity” to the market, thereby fulfilling an important role in providing commercial hedgers with needed counterparties. However, commodity index funds do not trade on the basis of supply and demand fundamentals or in response to liquidity demands. Rather, they trade on the basis of investment inflows and the need to perpetually roll contracts forward as they regularly expire. Gene Guilford - House Democratic Caucus - May 16, 2012

7. Growth of Commodity Index Funds Gene Guilford - House Democratic Caucus - May 16, 2012

8. NORDEA Abandons Speculation in Agricultural Commodities • In reviewing the history of the growth of speculative investments in agricultural commodities in the previous slide; • On May 10, 2012 NORDEA, a Danish bank, announced that it was abandoning offering its customers financial instruments investing in agricultural commodities, citing a number of international analyses which show a correlation between increased speculation and volatile (and record high) food commodity prices. Gene Guilford - House Democratic Caucus - May 16, 2012

9. 2007/08 – Closing the ENRON Loophole • The "Enron loophole" exempted most over-the-counter energy trades and trading on electronic energy commodity markets from government regulation. • The "loophole" was enacted in sections § 2(h) and (g) of the Commodity Futures Modernization Act of 2000, December 21, 2000. It allowed for the creation, for U.S. exchanges, of a new kind of derivative security, the single-stock future, which had been prohibited since 1982 under the Shad-Johnson Accord, a jurisdictional pact between John S. R. Shad, then chairman of the U.S. Securities and Exchange Commission, and Phil Johnson, then chairman of the Commodity Futures Trading Commission. • June 2007, the equivalent of 3 billion barrels of oil traded daily in paper markets, versus just 67 million barrels a day traded in the physical oil markets, according to OPEC Secretary General Abdullah al-Badri, speaking at a Reuters Global Energy Summit. • When speculators become dominant in the market for derivatives on consumable commodities, the supply- and demand-based trading of physical commodity producers takes a back seat to the high stakes trading of speculators as they attempt to out trade each other. • Part of this colossal corporate failure and its cost to consumers came as a result of federal regulators turning a blind eye to market activities and insisting on “supply and demand” as their excuse for market behavior. • The “loophole” was not effectively closed in the 2008 Farm Bill, leaving more work to be done in law. Gene Guilford - House Democratic Caucus - May 16, 2012

10. Supply and Demand – China and Index Funds - 2008 • Some economists point to China's demand for crude oil as the cause for the [then] recent rise in energy costs • 2008 Department of Energy report stated that annual Chinese demand for petroleum has increased over the last five years [2003-2008] by 920 million barrels. • Yet, over the same five-year period, index speculators' demand for petroleum futures has increased by 848 million barrels, thus the increase in demand from institutional investors is almost equal to the increase in demand from China. • The October 2007 Government Accountability Office report, Trends in Energy Derivatives Markets Raise Questions about CFTC's Oversight, determined that futures market speculation could have an upward effect on prices; however, it was hard to quantify the exact totals due to lack of transparency and record keeping by the Commodities Futures Trading Commission (CFTC). • Once again, lack of transparency, accountability and oversight left the country with energy markets being impacted by financial industry speculation and higher energy costs. Gene Guilford - House Democratic Caucus - May 16, 2012

11. 2008 - Supply and Demand – Fails – WTI Crude Oil July, 2008 $147 @ bbl May, 2008 Goldman Sachs Predicts $200 @ bbl crude March, 2008 $70 @ bbl There is no supply and demand argument for WTI crude oil that more the doubled its price in 5 months and then the absence of such supply and demand forced its collapse in the succeeding 5 months November, 2008 $32 @ bbl Gene Guilford - House Democratic Caucus - May 16, 2012

12. America’s Second Great Depression and Dodd-Frank • The near collapse of the nation’s financial system between 2007 and 2010, driven by the housing market bubble and misuse of derivatives in the very dark markets created by deregulation in 2000, resulted in a loss of some $16 trillion in national wealth – millions lost their jobs, homes and value of their homes and businesses. • Dodd-Frank, signed into law by President Obama in July of 2010, gave regulators many of the tools that are needed to bring order to markets through appropriate and necessary regulation, accountability, transparency and oversight. • The CFTC and SEC have been given new, broad powers to return to a pre-2000 period when federal oversight and regulation of financial markets was more involved and, with the exception of derivatives regulation, more successful. • With hundreds of rulemakings to be done by agencies, particularly in the area of regulating the nearly $600 trillion derivatives market, and faced with lawsuits from the financial services industry challenging the agencies at every turn, progress is slow. • Today, 9 banks are exposed to derivatives positions exceeding $200 trillion in notional value. That is almost three times the size of the entire global economy. • Our work is not finished, as agency rulemakings need to be completed. Wall Street seeks judicial nullification of the laws through lawsuits. Gene Guilford - House Democratic Caucus - May 16, 2012

13. 2012 - Trust Wall Street? • JP Morgan shocked everyone on the afternoon of May 10th with a surprise conference call from Chairman Jamie Dimon. Their 10Q revealed that they face way, way more losses than we thought. There's about $4.2 billion in legal losses, likely because of a trader named Bruno Iksil, the so-called “London Whale.” • Possibly a $800 million loss in corporate department after tax. • Possible $2 billion losses on synthetic credit positions. • "It could easily get worse this quarter," Dimon says. It is likely they'll be volatile for the next 2 quarters. • Bank analyst Mike Mayo asks: "Can mistakes be made in other departments?" Dimon answers—"We're not in the business where we're not going to make mistakes... I can never promise you no mistakes. This one we'll put in the egregious category." • JPMorgan's surprise trading loss is not only tanking the stock itself (which is down over 6% on the 10th) it's taking down world financial markets. • JP Morgan Chase has a derivative exposure of $70.151 Trillion dollars – roughly the size of the entire earth’s economy. • The Volcker Rule, a modern-day semi-replacement of the 1933 Glass-Steagall law separating commercial from investment banking, comes out this summer with aims at restricting proprietary trading. Wall Street is already screaming at its purposes, hoping the nation and policy-makers have amnesia about the last four years. • "In other words, JPMorgan Chase, entirely without any help from the government has lost, in this one set of transactions, five times the amount they claim financial regulation is costing them," Rep. Barney Frank, May 11, 2012 Gene Guilford - House Democratic Caucus - May 16, 2012

14. Drawing the Line from Wall Street to the Gas Pump • Financial industry speculators have overtaken commodity markets • 10 years ago actual producers and users of energy and agricultural commodities made up 70-80% of the markets, with only 20-30% speculators; • Now, that has flipped and 70-80% of the commodity markets are controlled by financial industry speculation and only 20-30% of the markets are the actual legitimate hedgers of purchases of energy and food; • 6 years ago Wall Street brought out commodity index funds, resulting in $200-$400 billion of strictly speculative investments in commodity markets and that is contributing to the rise in food and energy prices. Review how one Wall Street investment house sells these instruments… • "How do I sell something that I don’t own, or why would I buy something I don’t need". The answer is simple. When trading futures, you never actually buy or sell anything tangible; you are just contracting to do so at a future date. You are merely taking a buying or selling position as a speculator, expecting to profit from rising or falling prices. You have no intention of making or taking delivery of the commodity you are trading, your only goal is to buy low and sell high, or vice-versa. Before the contract expires you will need to relieve your contractual obligation to take or make delivery by offsetting (also known as unwind, or liquidate) your initial position. Therefore, if you oiginally entered a short position, to exit you would buy, and if you had originally entered a long position, to exit you would sell. [http://www.altavest.com/education/default.aspx] Gene Guilford - House Democratic Caucus - May 16, 2012

15. Mid-December 2011 to March, 2012 – CME/Crude Oil Gene Guilford - House Democratic Caucus - May 16, 2012

16. Mid-December 2011 to March 2012 – CME/Gasoline Gene Guilford - House Democratic Caucus - May 16, 2012

17. Mid-December 2011 to March 2012 – CME/Heating Oil Gene Guilford - House Democratic Caucus - May 16, 2012

18. Wall Street’s Reaction to the Fundamentals Taking Hold? • "It was a very overdone trade, and people are getting out of it," said Amrita Sen, an energy analyst at Barclays • "What you're seeing in the market is some back-pedaling from the hysteria we saw in February and March," said Sander Cohan, a principal at ESAI, an energy-consulting firm in Wakefield, Mass. • As futures prices drop, investor sentiment appears to be shifting. Hedge funds, pension funds and other money managers [non-commercial market participants] are reducing their bets that gasoline futures will rise. Those bets had jumped 35% between early January and early April. • Demand for gasoline, meanwhile, continues to be underwhelming. US DOE/EIA data showed there is nearly 3% more gasoline on hand at the moment than there was a year ago. In fact, domestic gasoline inventories were at the top of their 5-year averages and the US was a net exporter of refined petroleum products as well, of more than 250,000 barrels a day of finished gasoline and a total of over 1 million barrels a day of refined products generally. Gene Guilford - House Democratic Caucus - May 16, 2012

19. What Has This Mid-December to March Artificial Inflation Cost Us? • US Gasoline Consumption • 138,496,176,000 gallons annually • 11,541,348,000 gallons monthly • 380,000,000 gallons daily • CME/NYMEX Gasoline contract increase of 92c a gallon between mid-December and March 28th would translate into an increased cost of gasoline to American consumers of $10.6 billion per month in March versus December. • As the wholesale, physical markets are priced directly off the daily movements of the CME/NYMEX contract movements, we saw 70c per gallon increases in wholesale prices through the time of the 92c a gallon increases in the commodity contract; • The direct impact on American consumers was $266 million a day, or $8 billion per month, in higher gasoline costs by mid-March over prices charged in mid-December. • CME/NYMEX gasoline contract values have declined of late from their high of $3.40 down to $3.02 [5/10/2012], and are still 54c a gallon higher than last Mid-December. Gene Guilford - House Democratic Caucus - May 16, 2012

20. The Need for Transparency, Accountability and Oversight • The commodity markets are overseen by the CFTC [Commodity Futures Trading Commission], who put in place a position limits regulation after the first of year to restrain strictly financial speculation in these markets and the financial services industry sued the CFTC in federal court, saying the rules were not necessary; ask anyone buying energy or food, given these massive price increases, whether they think restraining the financial industry is necessary; • The financial services industry drove America nearly into another Great Depression in 2008, from which we are only now beginning to emerge. Congress passed the Dodd-Frank law to regulate the reckless and irresponsible behavior of Wall Street and that law, and all the agencies responsible for implementing that law, need to be strongly supported and the law needs to be allowed to work for the American people. • Due to the previously mentioned market distortions that resulted largely from trades in opaque markets, these activities need to be brought into transparent clearing to avoid systematic risk. Gene Guilford - House Democratic Caucus - May 16, 2012

21. Are the Effects of Speculation on Commodity Markets Clear? • Yes • There are 98 academic and public institution studies that prove the negative effects of speculation on commodity markets; • There are another 38 studies that demonstrate the harm to markets caused by High Frequency Trading; • The issue isn’t whether or not speculation is harmful – it is the degree to which excessive speculation damages the price discovery mechanism critical to commodity market success – and the necessary and appropriate government action needed to restrain it; • Opaque unregulated, uncleared, leveraged markets, tend to over shoot on the way up and down, AND send the wrong market signals to the physical markets for future investment. Gene Guilford - House Democratic Caucus - May 16, 2012

22. The Need for Transparency, Accountability and Oversight • 20% of the trades in areas mentioned here are within the scope of view of US regulators; • 80% are within ICE and the OTC market and, therefore, not yet within the scope of view of US regulators Gene Guilford - House Democratic Caucus - May 16, 2012

23. Our Job Is Not Done • We would throw all purely financial speculators out of these markets and make all energy and agricultural commodities 100% deliverable, which is to say if you invest in these markets you MUST be able to take actual delivery of the commodities you invest in - NOT simply play the Wall Street casino game of placing bets and bidding up the price of energy and food and leaving Americans with paying the bill; • Support adequate funding for the CFTC, reject proposals to cut their funding which only guts the agency’s ability to enforce the laws; • Support the efforts of the House Agriculture Committee to initiate hearings on the role excessive Wall Street oil speculation is having on gas prices; • Action by the Dept of Justice Task Force on Speculation, started last July, 2011 – must be undertaken immediately and without delay. • Support Representative Markey’s legislation, the “Halt Index Trading of Energy Commodities (HITEC) Act’’ (H.R. 5186) which would end speculative trading in energy commodities. • Support the "Sustainable Funding Act" (H.R. 3665) which would provide the CFTC with a permanent funding source. • The Volcker rule comes this summer, the modern-day version of the 1933 Glass-Steagall law whose intent is the restriction of proprietary trading by investment banks. Wall Street is already screaming at its intent and impact, as though the nation and policy makers should have amnesia about what has happened the last four years. Gene Guilford - House Democratic Caucus - May 16, 2012

24. Does Fixing Financial Market Speculation Alone Fix Energy Markets? No. There are three key areas of concern with energy prices; • Monetary policy that devalues the dollar and has some inflationary effect on dollar-denominated commodities traded in world markets; • Speculation in commodities by those with no intention of delivering anything tangible to a market nor taking delivery of anything tangible from a market – but whose billions of investment send false price signals and inflate commodity values; • Energy Policy, as with every 3% increase in GDP growth there is a 1% increase in energy demand. Energy policy, including energy conservation and domestic production are critical, but also need to be delivered into a market that sees fundamentals and real supply and demand – not the phantom short-term thinking of churning contracts and short-term profit in the casino that has become the commodity markets. Gene Guilford - House Democratic Caucus - May 16, 2012

25. Wall Street’s Strategy… • Sue. What they couldn’t change in Dodd-Frank ends up as rulemakings in agencies and the strategy is to litigate everything; • Stall. Flood agencies with comments [15,000 on the CFTC Position Limits Rule alone] so that most agencies’ rulemakings fall behind and hope Congress changes so that legislative changes can be enacted; • Bully Regulators. Threatening lawsuits isn’t the only tactic, threatening agency budgets in Congress is also part of the strategy as they attempt to undermine an agency’s ability to carry out its statutorily-directed functions and as that gets elongated – complain about regulatory uncertainty harming the economy; • Beg for Loopholes. As agencies make progress formulating and enacting rules, and as that progress and potential impacts become more clear, return to Congress and beg for exemptions and loopholes citing extraordinary costs in jobs and profitability. Gene Guilford - House Democratic Caucus - May 16, 2012

26. Finally…Transparency – Accountability - Oversight "This regrettable news from JPMorgan Chase [announcing its $2 billion loss] obviously goes counter to the bank’s narrative blaming excessive regulation for the woes of financial institutions," "The argument that financial institutions do not need the new rules to help them avoid the irresponsible actions that led to the crisis of 2008 is at least $2 billion harder to make today,“ "In other words, JPMorgan Chase, entirely without any help from the government has lost, in this one set of transactions, five times the amount they claim financial regulation is costing them," Representative Barney Frank, May 11, 2010. Gene Guilford - House Democratic Caucus - May 16, 2012